As the operations of a business become more stable, evaluating projects to improve present conditions or to start new endeavors that will bring more income becomes a vital activity to further growth. The difference between a well-managed company and one that is prone to financial surprises is that the former doesn’t jump straight into a new project without calculations or based simply on the CEO’s instincts.
The calculations that we will review on this post will not only serve as a complement for evaluating projects but also investments and purchases. When weighing the value of each of the different choices it’s also important to acknowledge that even doing nothing holds a value.
I’m assuming most of you have Excel since it makes things way easier, so when applicable I’ll indicate the formulas you can use for the different approaches in that program to evaluate a project and/or the mathematical formula behind it to do it on pen-and-paper.
Payback is used to find out when you can expect to obtain back the money invested. Unlike other calculations, payback is pretty simple and only requires knowing the expected expenses and income. It’s important to mention that it doesn’t consider the time value of money or the profits made after the investment is recuperated. It should only be used when the main concern is knowing approximately when you would get your money back instead of the real value of the investment. The formula is the following:
To illustrate how easy it is to estimate when the investment will be recovered but also the shortcomings of this calculation, we have the following example:
In this example the company is faced with two options. An investment for $100 that will provide a continuous cash flow of $40 or an investment for $200 that will provide a constant cash flow of $60. If you were solely interested in getting your money back as soon as possible, then according to the calculation Project A is the better choice since you get your money back sometime between period two and three, while with Project B you get your money back after period three. But you’ve probably noticed that in the long run Project B could be a better a project, something that is not analyzed when using the payback formula.
There is also a way to calculate the payback and discount the money by a reference rate. While this calculation still doesn’t take care of looking at the long-term profitability that a project might have, it does take into account the time value of money.
In this example we see that Project A still provides the fastest offset of the initial expense. For the discounted payback you still use the same formula as illustrated in the previous example, but use the corresponding amount from the discounted cash flow row instead. For the discounted cash flow I’ve also included the formula to be used on that row.
Do Benefits Outweigh Costs?
Now that you’re familiarized with discounting cash flows we can go over a more complex analysis and closer to reality. A project that not only will have an initial investment but also recurring expenditures. In this case, you can obtain the present value of both the costs and expected benefits at each period and subtract to see if the benefits outweigh the costs. If you would like an example of the how complex or how simple the calculation can be, I recommend visiting this link.
You can also calculate the cost-benefit ratio by dividing the discounted benefits by the discounted costs. This ratio shows if the benefits are greater than the costs if the ratio is greater than one. Also if comparing more than one project the one with the higher ratio is the better option (if how well a project covers its costs is the deciding factor).
Net Present Value
If you have a project with an initial investment and expected cash flow and you’re interested in knowing the net present value of each project given the time value of money and reference rate you can either use a model like the one shown for discounted payback and add all the discounted cash flows or you can use the function in Excel:
NPV(Reference Rate, Income Range) + Initial Disbursement
If the net present value is positive it means the project reviewed is a preferable over the investment that provided the reference rate and if you’re comparing two projects the one with the higher NPV is your best choice.
Modified Internal Rate of Return (MIRR)
The modified internal rate of return assumes that positive cash flows are reinvested at the firm’s cost of capital. The Excel function is:
MIRR(Range of Cash Flow, Finance Rate, Reinvest Rate)
As you can see in the example this project provides a higher return than the cost of capital, so it would be a better option. The higher the MIRR, the better.
The profitability index is also a quick method to know if a project is viable or not, through a simple assessment. If the profitability index is higher than one than you should go for it and if it’s less than one you shouldn’t. The formula can be either:
PI = 1+((PV of Future Cash Flow – Present Value of Cash Outflow) / Initial Investment)
PI = Present Value of Future Cash Flow / Initial Investment
Let’s say you have a project for which you have calculated that the net present value of the future cash flow is $150 million and the initial investment is $120 million: $150,000,000 / $120,000,000 = 1.25
This investment is profitable and unless there is another option with a higher profitability index this would be the project to select.
Other Factors to Consider
Using these formulas is just one part of the analysis and depending on the situation the company should decide how important the profitability, value, or recoup time is for them. A company should complement the financial side with additional research of other aspects and weight them based on what is more valuable for them. Imagine that a pharmaceutical company has the opportunity to launch a new medicine that has a strong profitability index, great net present value, and a short payback…but side-effects although rare could cause other ailments that are pretty grave, should it go for it? There are also cases where the venture is not profitable but it provides a much needed aid to society or the environment. In this case the social benefits would eclipse the financial costs.
Opportunity cost, collateral damage or pay offs, loosing the budget if it’s not used, and if projects are mutually exclusive or independent are some of the many aspects that can be investigated when evaluating a project.