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Project Cash Flows and Simple Payback

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**The Cash Flow Concept
**

The Cash Flow Concept is a common management planning tool. It distinguishes between: (a) costs -> cash outflows (b) revenues/savings -> cash inflows

Types Of Cash Flows Outflow Inflow Equipment salvage value Operating revenues & savings Working capital Initial investment cost Operating costs & taxes Working capital One-time Annual Other .

Working Capital Working Capital is: ´the total value of goods and money necessary to maintain project operationsµ It includes items such as: ² ² ² ² Raw materials inventory Product inventory Accounts payable/receivable Cash-on-hand .

Salvage Value Salvage Value is the resale value of equipment or other materials at the end of the project .

Timing of Cash Flows End of project: Salvage Value Annual Revenues/Savings Working capital Year 1 Year 2 Year 3 TIME Annual Operating Costs Annual Tax Payments Time zero: Annual Financing Working Capital Payments Initial Investment .

Analysis Structure There are two basic ways to structure a project financial analysis: 1) Stand-alone analysis Considers only the cash flows of the proposed project 2) Incremental analysis Compares the cash flows of the proposed project to the ´business as usualµ cash flows .

you will need to do an incremental analysis ³ compare the CP cash flows to the ´business as usualµ cash flows y You only need to estimate the cash flows that change when you improve the ´business as usualµ operations .Incremental Analysis for CP y For many CP projects.

is: ´a single number that is calculated for characterisation of project profitability in a concise.Profitability Indicators A profitability indicator.µ Common examples are: Simple Payback Return on Investment (ROI) Net Present Value (NPV) Internal Rate of Return (IRR) . understandable form. or ´financial indicatorµ.

Simple Payback This indicator incorporates: ² the initial investment cost ² the first year cash flow from the project Simple Payback (in years) = Initial Investment Year 1 Cash Flow .

. if the payback period is less than 3 years.g. then the project is viewed as profitable .How to Interpret Simple Payback The simple payback or ROI calculated for a project are usually compared to a company rule of thumb called a ´hurdleµ rate: e.

The Time Value of Money and Net Present Value (NPV) 13 .

. 14 . or (B) $10.000 3 years from now Explain your answer.. would you rather have: (A) $10.000 today.Question: If we were giving away money.

so a dollar today can buy more than a dollar next year.05 next year . inflation 5% costs $1 now costs $1.Inflation Money loses purchasing power over time as product/service prices rise.

10 a year from now Interest. or ³return on investment´ .Investment Opportunity A dollar that you invest today will bring you more than a dollar next year ³ having the dollar now provides you with an investment opportunity Investing $1 now Investment Gives you $1.

Time Value of Money (TVM) y Money now is worth more than money in the future because of: a) inflation b) investment opportunity y The exact ´time valueµ of your money depends on the magnitude of the: a) rate of inflation and b) rate of return on investment 17 .

over time. it is important to take the Time Value of Money (TVM) into account when you are estimating project profitability 18 .TVM and Project Profitability y When you invest in a capital project. you have: (1) An initial investment happening NOW (2) A series of future cash inflows. that pay back the initial investment y So.

Comparing Cash Flows from Different Years y Before you can compare cash flows from different years. you need to convert them all to their equivalent values in a single year y It is easiest to convert all project cash flows to their ´present valueµ now. at the very beginning of the project .

it is the reverse of an interest rate calculation .Converting Cash Flows to Their Present Value y You can convert future year cash flows to their present value using a ´discount rateµ that incorporates: ² Desired return on investment ² Inflation y The discount rate calculation is simple ³ mathematically.

Interest Rate Calculation Invested at an interest rate of 20%.20 = $12.20 x 1.20 = $17. how much will $10.000 = $14.20 $10.20 x 1.000 now be worth after 3 years? After year 1 2 3 $10.000 x 1.000 x 1.000 x 1.280 Note: these calculations are on a compound basis 21 .400 $10.20 x 1.

$17.20 x 1.20 x 1.280 in 3 years. If you want to have $17. how much would you have to invest now? $17.280 in year 3 has a present value of $10.000 needed now In other words.Discounting Calculation The discounting calculation is essentially the opposite of the interest rate calculation.280 1.000 22 .20 = $10.

pure compensation for deferring consumption ² Any ¶risk premium· for that project·s risk ² Any expected fall in the value of money over time through inflation 23 .Which Discount Rate? (1) y The discount rate a company chooses should be equal to the required rate of return for the project investment y The required rate of return will usually incorporate three distinct elements: ² A basic return .

the company·s ´cost of capitalµ) y Often. rather than trying to identify the exact source of capital (and its associated cost) for each individual project.Which Discount Rate? (2) y At a minimum. the chosen discount rate should cover the costs of raising the investment financing from investors or lenders (i. a firm will develop a single ´Weighted Average Cost of Capitalµ (WACC) that characterises the sources and cost of capital to the company as a whole. 24 .e.

7142 .8333 .6944 .0042 30% .7513 .0573 .4019 .1859 .1486 .0004 40% .5787 .3855 .8264 .4552 .2603 .3501 .1615 .2693 .5917 .Present Value Factors Value of $1 in the future. NOW Discount rate (d): 10% Years into future (n) 20% .0012 .0725 .5102 .0346 .0000 25 1 2 3 4 5 10 20 30 .0261 .4823 .6830 .7692 .0053 .6209 .3644 .9091 .

both negative (cash outflows) and positive (cash inflows) y NPV characterises the present value of the project to the company If NPV > 0. the project is profitable If NPV < 0. the project is not 26 .Net Present Value (NPV) y Net Present Value (NPV) = the sum of the present values of all of a project·s cash flows.

$??? $??? $??? $??? $??? 0 1 2 3 Sum = the project¶s Net Present Value = .Estimating Net Present Value Year Expected Future Cash Flows .463 + $38.$105.463 * PV Factor ??? ??? ??? ??? = Present Value of Cash Flows (at time zero) .000 + $38.463 + $38.

Interpreting Profitability Indicators 28 .

.Interpret Profitability Indicators With Caution.. y We have seen that Simple Payback has some limitations as a project profitability indicator y Be aware of the advantages and limitations of the indicators you use 29 .

.. e. disposal fees at landfills y Short time horizons neglect the impact of the time value of money. changing cost 30 of capital. especially in times of significant inflation. deflation. . a required wastewater treatment plant upgrade in the future y Some annual operating costs may change significantly over time.Some Good Reasons to Use a Longer Analysis Time Horizon y Some out-year costs may be missed if the time horizon is too short. etc.g.g. e.

. the best approach is to do the financial analysis with several reasonable values. to illustrate a corresponding range of results.Sensitivity Analysis y In the absence of a reliable estimate of a company·s cost of capital. y This type of sensitivity analysis can also be done if other data in the analysis are uncertain.

Profitability Assessment Tips Be sure to: ² Include all relevant and significant costs/savings in the profitability analysis ² Think long-term (or at least mediumterm!) ² Incorporate the time value of money ² Use multiple profitability indicators ² Perform sensitivity analyses for data estimates that are uncertain 32 .

then the project is viewed as profitable . then the project is viewed as profitable ² e..How to Interpret Simple Payback and ROI y The simple payback or ROI calculated for a project are usually compared to a company rule of thumb called a ´hurdleµ rate: ² e.g. if the project payback period is less than 3 years.g. if the ROI is 33%..

using the company·s cost of capital as the discount rate .Net Present Value (NPV) y NPV is a more reliable profitability indicator that considers both the time value of money and all future year cash flows y NPV = the sum of the discounted cash flows over the lifetime of the project.

g. the project is profitable over that time horizon y If the calculated NPV is less than zero.How to Interpret NPV y NPV is calculated over a chosen time horizon(s). e.. the project is not profitable over that time horizon . 5 years y If the calculated NPV is greater than zero.

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