Project Profitability

Assessment

1
 Contents
 Capital budgeting (of “environmental”
projects)
 Project cash flows and simple payback
 The Time Value of Money (TVM) and
Net Present Value (NPV)
 Two small group exercises
 Capital budgeting with inflation and tax
 Sensitivity analysis
 Key profitability indicators 2
 Capital Budgeting
(of “Environmental” Projects)
[15 min]

3
 Capital budgeting

The process by which an organization:

 Decides which investment projects are
needed & possible, with a special focus
on projects that require significant up-
front investment (i.e., capital)
 Decides how to allocate available
capital between different projects
 Decides if additional capital is needed

4
 Capital budgeting practices
 Capital budgeting practices vary widely
from company to company
– Larger companies tend to have more formal
practices than smaller companies
– Larger companies tend to make more and
larger capital investments than smaller
companies
– Some industry sectors require more capital
investment than others
 Capital budgeting practices may also vary
from country to country 5
Typical project types & goals (1)
 Maintenance
– Maintain existing equipment and operations
 Improvement
– Modify existing equipment, processes, and
management and information systems to
improve efficiency, reduce costs, increase
capacity, improve product quality, etc.
 Replacement
– Replace outdated, worn-out, or damaged
equipment or outdated/inefficient management
and information systems
6
Typical project types & goals (2)
 Expansion
– e.g., obtain and install new process
lines, initiate new product lines
 Safety
– make worker safety improvements
 Environmental
– e.g., reduce use of toxic materials,
increase recycling, reduce waste
generation, install waste treatment
 Others... 7
 The poor reputation of
“environmental” investment projects
Many people in industry view
“environmental” projects as increasingly
necessary to stay in business, but as
automatic financial losers because:

– they associate “environmental projects” with

pollution control systems such as wastewater
treatment plants, which can be quite costly (end-
of-pipe)
– they are unaware of the potential financial
benefits of preventive environmental
management practices 8
 We know better!
 We have learned that some environmental
projects, i.e., Cleaner Production (CP)
projects, can go hand in hand with:
– Production efficiency improvements
– Product quality improvements
– Production expansion
 So, do not place your project idea into a
single narrow category — think broadly
about all the possible benefits

9
 Decision-making factors
Today’s focus
Technical

Project
Regulatory Financial
selection

Organizational

10
Project Cash Flows
and
Simple Payback

[15 min]

11
 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

12
 Cash Flow Analysis

• Relies on every day life principles

• Measures the difference between

– What we received, and
– What we paid out

• Only cash receipts and cash payments are

included in the analysis
• Applicable also to forecast cash available 13
 Types of Cash Flows
Outflow Inflow
Initial Equipment
One-time investment salvage
cost value
Operating Operating
Annual costs & revenues
taxes & savings
Working Working
Other capital capital

14
 Cash Outflow Analysis (1)

INITIAL INVESTMENT

• Planning/ Engineering • Utility Systems &

• Permitting Connections

• Site Preparation • Start-up/Training

• Purchased Equipment • Contingency

• Working Capital • (Salvage Value) 15

 Working Capital

Working Capital is: “the total value of

goods and money necessary to maintain
project operations”

It includes items such as:

– Raw materials inventory
– Product inventory
– Accounts payable/receivable
– Cash-on-hand
16
 Salvage Value

Salvage Value is the resale value of

equipment or other materials at the
end of the project

17
 Cash Outflow Analysis (2)

•Direct costs

•Input costs

•Other costs

•Loan repayments

•Interest on loan application 18

 Cash Inflow Analysis
•Sales

•Savings

•Salvage value

•Cash shortfall / surplus

19
Cash Flow Forecast/Projection
(1)
•We are looking at the likely future
cash position.

•We examine the possible effects of

changes in the cash flow components .

20
Cash Flow Forecast/Projection
(2)
 Make assumptions about likely outcomes
regarding:
– Inflation
– Market size
– Demand for goods and services
– Interest Rates

21
Cashflow Projection Worksheet
Investment Year 0 1 2 3
INITIAL INVESTMENT
Total Investment Costs

OPERATING COSTS
Total Operating Costs

OPERATING AND MAINTENANCE

Total Operating and Maintenance Costs

WASTE MANAGEMENT
Total Waste Management Costs

COMPLIANCE AND REG. (Less

Tangibles)
Total Compliance Costs

REVENUES AND SAVINGS

REVENUES
Operating Costs
Less Depreciation
Taxable Income
Tax payable 22
Net Income after Depreciation and Tax
Annual Operating Costs & Savings
(see also Cleaner Production Investment Decision: Costs and
Savings checklist)

Operating Waste Management Less Tangibles

Inputs includes waste handling, recycling, • Productivity
treatment, disposal, and regulatory • Future regulation
compliance
• Materials • Potential liability
• Materials • Insurance
• Energy • Company image
• Energy
• Labour Revenues
• Labour
• Floor Space • Product sales
• Floor space • By-product sales
• Taxes
• Fees • Pollution credits
• Depreciation
• Taxes & Depreciation
• Cost of capital • Cost of Capital
23
 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
24
 Cash Flow 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 usual” cash flows

25
 Incremental analysis for CP
 For many CP projects, you will need
to do an incremental analysis —
compare the CP cash flows to the
“business as usual” cash flows
 You only need to estimate the cash
flows that change when you improve
the “business as usual” operations

26
 Profitability indicators
A profitability indicator, or “financial
indicator”, is: “a single number that is
calculated for characterisation of project
profitability in a concise, understandable
form.”
Common examples are:
• Simple Payback
• Return on Investment (ROI)
• Net Present Value (NPV)
• Internal Rate of Return (IRR)

27
 Simple payback
This indicator incorporates:
– the initial investment cost
– the first year cash flow from the
project

Simple Initial Investment

=
Payback
(in years) Year 1 Cash Flow

28
 How to interpret
simple payback
The simple payback calculated for a
project is usually compared to a
company rule of thumb called a
“hurdle” rate:

e.g., if the payback period is less

than 3 years, then the project is
viewed as profitable

29
 Small Group Exercise:
Profitability Assessment
at the PLS Company— Part I
“Cash Flows & Simple Payback”

[30 min]

30
 The PLS company’s
QC camera project
 PLS decided to purchase and install a
camera system to monitor quality control
(QC) of the print jobs as they actually
occur
 Allows the operators to detect print
errors earlier and halt the operations
before too much solid scrap is generated
 Has reduced generation of full-run solid
scrap by about 40%
31
 Costs and savings
included in the QC camera analysis
 Initial investment costs
– purchase of the camera system, delivery,
installation, start-up
 Annual operating costs (and savings)
– Operating input — materials (plastic film,
ink), energy, labour
– Incineration — fuel, fuel additive, labour,
ash to landfill
– Wastewater treatment — chemicals,
electricity, labour, sludge to landfill
32
 QC camera project
Cash flows
Annual savings = ???

Year 1 Year 2 Year 3 TIME

Annual Tax Payments = 0 (PLS has tax holiday)

Financing Payments = 0 (PLS paid cash)

Time zero:
Working Capital = 0 (not important for this project)
Initial Investment = $105,000
33
 The PLS company’s
QC camera project
Initial Annual
Investment Operating
Cost Costs
Business
As 0 ???
Usual Annual
Savings =
The QC ???
Camera US $ 105,000 ???
Project

34
 Exercise instructions
Part I
 Introduction (5 min.), detailed in
your handout
 Question 1 (15 min.)
 Question 2 (5 min.)
 Discuss your answers with the
other small groups and the
instructor (5 min.)

35
The Time Value of Money
and
Net Present Value (NPV)
[30 min]

36
 Question:

If we were giving away money,

would you rather have:
(A) $10,000 today, or
(B) $10,000 3 years
from now
Explain your answer...
37
 Inflation
Money loses purchasing power over time
as product/service prices rise, so a
dollar today can buy more than a dollar
next year.

inflation 5%

costs $1 costs $1.05

now next year 38
 Investment opportunity
A dollar that you invest today will bring
you more than a dollar next year —
having the dollar now provides you with
an investment opportunity

Investing Gives you

Investment $1.10 a year
$1 now
from now

Interest, or
“return on investment”
39
 Time Value of Money (TVM)
 Money now is worth more than
money in the future because
of:
a) inflation
b) investment opportunity

 The exact “time value” of your

money depends on the
magnitude of the:
a) rate of inflation and
b) rate of return on investment

40
 TVM and project profitability

 When you invest in a capital project, you

have:
(1) An initial investment happening NOW
(2) A series of future cash inflows, over time,
that pay back the initial investment

 So, it is important to take the Time

Value of Money (TVM) into account when
you are estimating project profitability

41
 The PLS company’s
QC camera project
Initial Annual
Investment Operating
Cost Costs
Business
As 0 $ 2,933,204
Usual Annual
Savings =
The QC US$38,463
Camera $ 105,000 $ 2,894,741
Project

(in US$)
42
 Question:

Is the annual savings of

$38,463 per year for 3 years
a sufficient return
on the initial investment of
$ 105,000?

43
 Answer?
You might think about adding up the
annual savings over the 3 years:

Savings per year $38,463

x 3 years
Total savings $115,389

But: this ignores the Time Value of Money

(the fact that $38,463 in year 1 is not the
same as $38,463 in year 2 or year 3)
44
 Comparing cash flows
from different years
 Before you can compare cash flows
from different years, you need to
convert them all to their equivalent
values in a single year
 It is easiest to convert all project
cash flows to their “present value”
now, at the very beginning of the
project
45
 Converting the PLS cash flows
to their “present value”
Annual Savings End of project
= ??
= ??
= ??
$38,463 $38,463 $38,463

Year 1 Year 2 Year 3 TIME

Time zero:
Initial Investment = $105,000
46
 Converting cash flows
to their present value
 You can convert future year cash
flows to their present value using a
“discount rate” that incorporates:
– Desired return on investment
– Inflation
 The discount rate calculation is simple
— mathematically, it is the reverse of
an interest rate calculation
47
 Interest rate calculation
Invested at an interest rate of 20%, how
much will $10,000 now be worth after 3
years?

After
year
1 $10,000 x 1.20 = $12,000
2 $10,000 x 1.20 x 1.20 = $14,400

3 $10,000 x 1.20 x 1.20 x 1.20 = $17,280

Note: these calculations are on a compound basis

48
 Discounting calculation
The discounting calculation is essentially
the opposite of the interest rate
calculation.

If you want to have $17,280 in 3 years,

how much would you have to invest now?
$17,280 = $10,000
1.20 x 1.20 x 1.20 needed now

In other words, $17,280 in year 3 has a

present value of $10,000
49
 Which discount rate? (1)
 The discount rate a company chooses should
be equal to the required rate of return for
the project investment
 The required rate of return will usually
incorporate three distinct elements:
– A basic return - pure compensation for deferring
consumption
– Any ‘risk premium’ for that project’s risk
– Any expected fall in the value of money over time
through inflation

50
 Which discount rate? (2)
 At a minimum, the chosen discount rate should
cover the costs of raising the investment
financing from investors or lenders (i.e. the
company’s “cost of capital”)
 Often, rather than trying to identify the exact
source of capital (and its associated cost) for
each individual project, a firm will develop a
single “Weighted Average Cost of Capital”
(WACC) that characterises the sources and
cost of capital to the company as a whole.

51
 Discounting (1)
The value of the
cash flow in year n

Present Value = Future Valuen

(1 + d)n

The value of the n = the number

cash flow at d = the of years after
“Time Zero,” i.e., discount rate project start-up
at project start-up

52
 Discounting (2)
The value of the
cash flow in year n

Present Value = Future Valuen x (PV Factor)

The value of the Present Value (PV) Factors have

cash flow at been calculated for various
“Time Zero,” i.e., values of d (discount rate) and n
at project start-up (number of years) and have been
tabulated for easy use.
(Also called discount factors)
53
 PresentValue factors
Value of $1 in the future, NOW
Discount rate (d): 10% 20% 30% 40%
Years into future (n)
1 .9091 .8333 .7692 .7142
2 .8264 .6944 .5917 .5102
3 .7513 .5787 .4552 .3644
4 .6830 .4823 .3501 .2603
5 .6209 .4019 .2693 .1859
10 .3855 .1615 .0725 .0346
20 .1486 .0261 .0053 .0012
30 .0573 .0042 .0004 .0000
54
 Net Present Value (NPV)
 Net Present Value (NPV) = the sum of
the present values of all of a project’s
cash flows, both negative (cash
outflows) and positive (cash inflows)

 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

55
 Estimating
Net Present Value

Expected Present Value of

Year Future Cash PV = Cash Flows
* Factor
Flows (at time zero)

0 - $105,000 ??? - $???

1 + $38,463 ??? $???
2 + $38,463 ??? $???
3 + $38,463 ??? $???

Sum = the project’s Net Present Value = $??? 56

Time for lunch!
[60 min]

57
 Small Group Exercise:
Profitability Assessment
at the PLS Company— Part II
“Net Present Value”

[45 min]

58
 Also —
you will need the handout:

“Performing Net Present Value

(NPV) Calculations”

Located in your handout

59
 Converting the PLS cash flows
to their “present value”
End of project
= ??
= ??
= ??
$38,463 $38,463 $38,463

Year 1 Year 2 Year 3 TIME

Time zero:
Initial Investment = $105,000
60
 Exercise instructions
Part II
 Introduction (5 min.), detailed in
your handout
 Question 3 (15 min.)
 Question 4 (5 min.)
 Discuss your answers with the
other small groups and the
instructor (15 min.)
 Lessons learned (5 min.)
61
Capital Budgeting:
inflation & tax

[30 min]

62
 Discounting and inflation (1)

 even without inflation, money has a

time value due to supply/demand for
money
 inflation increases both:
- future cash flows
- interest rates (and  discount rates)
 these offset each other

63
 Discounting and inflation (2)

With 10% inflation (say), future cash flows

will  by 10% each year

Investors & lenders will also require a higher

rate to compensate for their loss in
purchasing power

If 15% was acceptable with no inflation, with

10% inflation they will now require

115% x 110% = 126.5% 64

 Discounting and inflation (3)
PLS Company, now assuming 10% inflation and 26.5%
discount rate:
Year Cash flow PV factor PV
($) @ 26.5% ($)
1 42,309 0.791 33,466
2 46,540 0.625 29,088
3 51,194 0.494 25,289
87,843
less: initial investment 105,000
Net Present Value -17,157

i.e. same NPV* as with zero inflation, 15% discount rate

* ignoring minor rounding difference
65
What is the current rate of inflation in
the economy?

What return on their capital will the

lender really earn on their money,
after allowing for the erosion of their
capital over time through inflation?

66
 Tax payments
 Taxes can be an important project cash
flow
 Depending on a facility’s location, a firm
may have to pay national and/or local
income taxes on the revenues or savings
generated by a project
 Other types of taxes may also be
relevant - sales taxes, pollution taxes,
etc.
67
 Tax deductions or credits
 Tax deductions or credits can also be
important
 One example is the income tax deduction
often given for equipment depreciation,
which is the loss in value of a physical
asset (e.g., a piece of equipment) as the
asset ages
 Some “environmental” investments can
receive special tax credits
68
 Tax and project appraisal

 assume 30% rate of taxes of firms’

profits
 tax is based on accounting profits, not
on cashflows
 accounting profits are after deducting
depreciation
 tax is payable 1 year after the
profits have been realised
69
 Depreciation

 A project needs $12,000 for a new

machine which will last 3 years
 assume the machine has no residual
value after 3 years
 depreciation per year:
initial cost = $12,000 = $4,000 per year
asset life 3 years

70
 Profit earned by project

 Profit earned by project in each year:

cash inflow per year $6,000
less: depreciation $4,000
contribution to profit $2,000

tax @ 30% $600

71
 NPV of project, with tax
time cash tax net PV PV
factor

now -12,000 -12,000 1.000 -12,000

1 +6,000 +6,000 0.833 +5,000
2 +6,000 -600 +5,400 0.694 +3,750
3 +6,000 -600 +5,400 0.579 +3,125
4 -600 -600 0.482 -289

Net Present Value - $414

72
Project appraisal with inflation
and tax

 depreciation (and accounting profits) are

based on the asset’s original cost

 the asset’s original cost does not increase

with inflation over the life of the project

 project analysis is then easier using

nominal (not real) cashflows and discount
rates
73
 Some good reasons to use a
longer analysis time horizon
 Some out-year costs may be missed if the
time horizon is too short, e.g., a required
wastewater treatment plant upgrade in the
future
 Some annual operating costs may change
significantly over time, e.g., disposal fees at
landfills
 Short time horizons neglect the impact of the
time value of money, especially in times of
significant inflation, deflation, changing cost
of capital, etc. 74
Profitability assessment tips

Be sure to:
– Include all relevant and significant
costs/savings in the profitability analysis
– Think long-term (or at least medium-
term!)
– Incorporate the time value of money
– Use multiple profitability indicators
– Perform sensitivity analyses for data
estimates that are uncertain
75
Time for a break!
[15 min]

76
Sensitivity Analysis

[15 min]

77
 Sensitivity Analysis
Introduction
An important management tool questioning
potential project benefit risks.

Assumptions surrounding a project are

computed to produce a base NPV and IRR.

From the base case, changes in the original

assumptions are made to gauge their effect on
the NPV and IRR.

Input variables varied adversely by 10% 78

 Sensitivity Analysis
Example
Input Variables Varied by 10%

Original 10% increase 10% increase 10% decrease

Data in Cost of in Investment in cashflows
Capital cost

Year 0 -2735000 -11323650 -12456015 -2735000

Year 1 -14978753 12951647 -14978753 -14828965
Year 2 17122990 2592375 17122990 16951760
Year 3 8022274 5151626 8022274 7942051
Year 4 376354 117364 376354 372590.5
Year 5 8203865 374538 8203865 8121826
Year 6 76133 5142598 76133 75371.67
Discount 35% 48,5% 35% 35%
Rate
Project Life 5 years 5 years 5 years 5 years
NPV 7810 -$2,741,092 -$8,940,009 $745,846
IRR 39% 54% 9% 39%
79
 Sensitivity Analysis
Summary

 Sensitivity Analysis permits project proposals

to be evaluated simply.

The model can evaluate sensitive variables

without having to input any additional data.

80
 Sensitivity Analysis
Conclusion
•By amending the original data, a variable
whose change generates a negative NPV
and /or an IRR lower than the firm’s cost
of capital, is deemed to be sensitive.

•An investigation would need to be

undertaken for a contingent plan. If
results of the investigation are
unfavourable, the project is unacceptable
on economic grounds.
However, development projects with social
81
 Key
Profitability Indicators
[15 min]

82
 Profitability indicators
We have seen so far:
• Simple Payback
• Net Present Value (NPV)

But there are others, common

examples are:
• Return on Investment (ROI)
• Internal Rate of Return (IRR)

83
 Simple Payback and
Return on Investment (ROI)
These indicators incorporate:
– the initial investment cost
– the first year cash flow

Simple Payback Initial Investment

=
(in years) Year 1 Cash Flow

Year 1 Cash Flow

ROI (in %) =
Initial Investment
84
 How to interpret
Simple Payback and ROI
 The simple payback or ROI calculated
for a project are usually compared to a
company rule of thumb called a “hurdle”
rate:
– e.g., if the project payback period is less
than 3 years, then the project is viewed
as profitable
– e.g., if the ROI is 33%, then the project
is viewed as profitable
85
 Net Present Value (NPV)

 NPV is a more reliable profitability

indicator than Simple Payback or ROI
as it considers both the time value of
money and all future year cash flows

 NPV = the sum of the discounted cash

flows over the lifetime of the project,
using the company’s cost of capital as
the discount rate 86
Internal Rate of Return (IRR)
 IRR is similar to NPV in that it considers
both the time value of money and all
future year cash flows
 IRR = the discount rate for which NPV =
0, over the project lifetime (calculated
in an iterative fashion)
 It tells you exactly what “discount rate”
makes the project just barely profitable

87
 Profitability indicator summary
(1)
Advantage Disadvantage

Simple
Payback Easy to use Neglect TVM
Neglect out-year costs
& ROI Do not indicate project size

Considers TVM Needs firm’s discount rate

NPV Indicates project size

IRR Considers TVM Requires iteration

Does not indicate project size

88
Profitability indicator summary
(2)
 NPV is generally the most valuable,
problem-free indicator
 Other indicators that consider the time
value of money (e.g., IRR) are also useful
 Payback and ROI are easy to understand
and use, but of limited accuracy
 However, Simple Payback is particularly
useful with uncertain or risky investment
climates
89
 Interpret profitability
indicators with caution...
 We have seen that Simple Payback has
some limitations as a project profitability
indicator

 Be aware of the advantages and limitations

of the indicators you use

 The best approach is to use several

indicators to give a balanced view of
project profitability 90
Other Profitability
Assessment Issues
[15 min]

91
 Other issues

 There are other issues that impact a

project’s profitability, which we do
not have time to address today
– Source and cost of project financing
– Can you think of others?

92
 Project financing

 Different sources of project financing

may have differing impacts on project
profitability
 Be sure to take financing payments
such as lease payments or payments
on loan principal and interest into
account appropriately when estimating
profitability
93
Project Profitability Assessment

Summary and Q&A

[15 min]

94
Project profitability assessment
 Capital budgeting (of “environmental”
projects)
 Project cash flows and simple payback
 The Time Value of Money and Net
Present Value (NPV)
 Two small group exercises
 Capital budgeting : inflation and tax
 Sensitivity analysis
 Key profitability indicators 95