Financial Evaluation of Projects
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Transcript of Financial Evaluation of Projects
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Enlighten.Me [email protected]
http://enlightenmetraining.wordpress.com/
http://www.facebook.com/enlighten.me.training
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Why do a financial evaluation?
An economic valuation of a project may be complex, but the reason
for doing one is simple. It is to answer one question :
In comparison to the alternative options, such as differentresources, different locations, different technology, different
schedules or even doing nothing...
Does this project represent the best possible
value for money?
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In receivership after less than a year!
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How many thousand cars per day?
27
59 60
100110
135
Average No toll Opening 2012 2014 2026
ForecastActual
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How do you value a project?
The most common way of valuing a project is to determine the net
present value (NPV) of its cash flows.
Consider all the money that will be spent or earned on a particularproject and calculate the value of that money in todays terms.
NPV =FVt
(1 +i)tNt=0
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Discounting
Lunch and Learn Economic Valuation of Projects
To value a future cash flow in todays terms we need to discount it.
This is where we answer questions like If we receive $5m in 6 years
time, what is that worth today?
We apply a discount rate against each cash flow and factor in the
number of periods it occurs in the future.
NPV =FVt
(1 +i)tNt=0
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What rate do we use?
Lunch and Learn Economic Valuation of Projects
The discount rate can consider things such as :
The cost of finance (interest or WACC),
Risk or
Required rate of return.
NPV =FVt
(1 +i)tNt=0
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Cash is king!
When performing an NPV calculation, we always work with
cash flows.
Usually we focus on the following four cash flows : Sales (Quantity x price)
Capital expenditure (Buildings, Software, Hardware)
Operating expenditure (Salaries, Maintenance, Electricity)
Tax (Income tax, other taxes or concessions)
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Calculating NPV
Lunch and Learn Economic Valuation of Projects
NPV =FVt
(1 +i)tNt=0
If we add the present value of the cash flow for every year, we get
the present value of a project. Greater than zero is the goal!
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
- $1,000 -$100 $200 $500 $800 $600 $400
-$ 909
-$ 83
$ 150
$ 342
$ 497
$ 339
$ 205$ 541
Value in todays terms
(discounted at 10%)
10%
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Calculating IRR
Lunch and Learn Economic Valuation of Projects
NPV =FVt
(1 +i)tNt=0
The rate at which NPV = zero is the internal rate of return (IRR).
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
- $1,000 -$100 $200 $500 $800 $600 $400
-$ 813
-$ 66
$ 108
$ 219
$ 285
$ 174
$ 94$ 0
IRR is the rate at which the NPV = zero
22.93%
= 0
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Simple example
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Dealing with uncertainty
Determining the exact amount of cash a project is going to generate
is not easy. Its probably impossible.
We should have a plan for considering the impact of thisuncertainty.
3 common approaches are
Do nothing
Build a Low, Medium and High Case
Build a probalistic model
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What are the chances?
What are the odds of flipping tails with a coin?
What are the odds of flipping tails three times in a row?
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Money has a shelf life
Lunch and Learn Economic Valuation of Projects
It is much better to have $1,000
today than tomorrow.
Why is this important?
It is much better to have positivecash flows earlier in a project (and to
try and delay cash outflows)
Time is money Benjamin Franklin
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Dont forget about tax
Lunch and Learn Economic Valuation of Projects
Most people know that tax reduces
the amount you earn, but dont
forget about the benefits.
Why is this important?Changing capital costs will not
deliver the entire cost increase or
saving as you will gain or lose on tax
too.
This is too difficult for a mathematician.It should be asked of a philosopher.Albert Einstein (filling out his tax return)
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Beware the butterfly effect
Lunch and Learn Economic Valuation of Projects
Evaluation models are often complex
and involve multiplying costs by cost
drivers. There is a risk a small change
can have a big impact on value.Why is this important?
While working in a model, you must
constantly track that the impact on
NPV is expected and acceptable.
Change one thing, change everything.Tagline for the movie The Butterfly Effect
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Change control is your friend
Lunch and Learn Economic Valuation of Projects
Record changes to assumptions and
their impact on value in a model.
Why is this important?As models are generally fairly complex,
it is easy to get lost and forget what
has been included in the model and
excluded from the model.
It is not the strongest of the species that survive, nor the most intelligent, butthe one most responsive to change.Charles Darwin
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Excel does not always equal Excellent
Lunch and Learn Economic Valuation of Projects
A complex financial model means high
probability for human error. These can
be inconsequential, but they can also
lead to the wrong decision.Why is this important?
Check and review your financial
models. Develop expectations on value
and challenge the output.
The good news about computers is they do what you tell them to do. The badnews is that they do what you tell them to do.Ted Nelson
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The model is one chapter in the story
Lunch and Learn Economic Valuation of Projects
The financial evaluation is just one
component of the final decision.
Why is this important?The model itself does not generate an
answer. You must understand the
various options being considered and
the qualitative impacts of them.
The only people who see the whole picture are the ones whostep out of the frame.Salman Rushdie, The Ground Beneath Her Feet
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