In the first part of this series, I talked about the different methods to evaluate the effectiveness of financial management, within those there are several criteria to assess the efficiency and profitability of investments and overall the decision making process, therefore I would like to dig a little deeper on the subject.
First of all I would like to begin with capital budgeting, which in summary is the process that a company follows to finance large expenditures or investments such a building new facilities, purchase of fixed assets, etcetera; due to this fact it’s extremely important to perform investment appraisals, so those appraisals have a huge umbrella of options to be tackled with, and the most commonly used criterias are:
Net Present value (NPV)
This metric intends to assess what would be the current value of an investment based on initial and continuous investments (for the specific project), net cash flows, discount rates and the number of periods the project will last.
For this metric the cornerstones are the discount rate and the net cash flows (NCF) because the decision making process will be backed up on the NPV is higher than the initial investment. It’s important to understand that the discount rate is applied to NCF in order to adjust its value, therefore the discount rate is indirectly proportional to the NPV, which means that a higher rate a lower NPV and viceversa; Discount rate calculation may vary according to the source of the investments, as per instance, we may use capital cost for retained earnings, the cost for issuing common stock, debt cost, weighted average cost of capital (WACC) or even opportunity cost; as I said, it will be directly linked to the source of the investment.
Internal rate of return (IRR)
This metric intends to compare the actual NPV return rate against the rate where NPV equals zero, in the event that the current rate is higher than the rate where NPV equals zero, then the project should be approved. In this case the driver for the calculation is directly linked to the accuracy of NCF, as this will be the basis for the calculations of NPV and consequently IRR.
Payback Period
This is probably one of the most common and simplest methods, which requires to compare the invested amount versus NCF and based on that, calculate the amount of periods where the investment will be recovered; it’s quite important to say this is not related to the profits for the project but cash inflows, because at the end of the day we want to understand how long it will take for the investment project to generate enough cash to cover the original disbursements. This represents a very straight forward way of analyzing the viability of a project, although as the rest of the metrics, it requires an important degree of accuracy over NCF calculations, which implies that we might need to include every item required in the project including not only operational expenditures, fixed asset investments (excluding depreciation), financial cost and so on and so forth.
Profitability Index
This method is based on future NCF, which requires an accurate calculation over the expected resources used and gained by the project; this appraisal represents how much cash will be generated over the lifetime of the project against the initial investment; therefore the minimum accepted index must be 1, if the calculated index lower than that, the project will not generate enough cash to cover the initial investment. The formula for the profitability index is NPV over initial investment.
Weighted Average Capital Cost (WACC)
The WACC is a calculation based on the source of the cash inflows; this funding may come from internal resources, via bonds, or any other long term debt and even the issuance of common or preferred stocks, therefore, in order to accurately assess the financial cost of the discount rate; it’s quite important to clearly identify its sources. Basically it means that we need to proportionally weight how much funding has been provided by each source tied to its respective rate, once we have that, we will be able to find the total financial cost and the right rate to be considered as discount rate.
The usage of WACC may help in the accuracy of calculations for the aforementioned metrics and it will also deliver the most accurate discount rate due to the fact that it considers every source of funding.
The decision making process we use on financial management regarding investment projects must always be backed up by these investment appraisal metrics. Every investment project requires a commitment of large amounts of financial resources, so forecasting the expected result of an investment project is a must.
On my next delivery I will talk about Capital Structure.
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