An investment project can be a crucial step in growing your business and achieving your strategic goals. Ask the following questions when evaluating your investment project.
1. Is it a good strategic fit and the right timing?
2. What are the impacts on your cash flow?
3. Is it a good investment?
Various analysis methods are:
Free cash flow (FCF) is a measure of a company's financial performance, calculated as operating cash flow minus capital expenditures. FCF represents the cash that a company is able to generate after spending the money required to maintain or expand its asset base.
ABC Company’s annual operating income (EBIT) =$100,000, Tax Rate 15%, Yearly depreciation expense =$5,000, Capital expenditure on equipment purchase = $20,000, Change in net working capital =$10,000 ABC Company’s current year FCF = $100,000 (1-15%) +$5000 -$20,000+$10,000 = $80,000
The calculation tool for FCF is available here.
An investment starts with initial cash outflow, and expects the cash inflow over a period of time. Because of time value of money, it is not a direct comparison between initial investment and future returns. A simple way is to convert all future cash inflows to values at present time. The difference between cash outflow and cash inflows at the present time are net present value (NPV). The formula for NPV of a project with multiple cash inflows is shown below:
\[NPV = CF_0 + {CF_1 \over {\left(1+r\right)^1} } + {CF_2 \over {\left(1+r\right)^2} } + {CF_3 \over {\left(1+r\right)^3} } + ... + {CF_n \over {\left(1+r\right)^n} } \tag{1}\label{eq1} \]where
The first term in NPV formula is the initial cash outflow. The remaining terms are the current values of a future stream of payments using the proper discount rate. NPV formula indicates the present value of future money depends on the discount rate and time period. The discount rate is the cost of capital (interest rate) or the rate of return that could be earned on an alternative investment with similar risk. This higher the discount rate or the longer the time period, the lowwer present value of future cash inflows.
A basic NPV calculation example: Company ABC invested a three-year project with an initial investment of $200k and a cost of capital of 10%. The return in next 3 years expected will be $80k, $80k, and $120k. The NPV of this project is calculated as follows:
\[ NPV = -200k + {80k \over (1+10\%)^1} + {80k \over (1+10\%)^2} + {120k \over (1+10\%)^3} = 29k \]The NPV of this investment is positive, which means its rate of return exceeds the discount rate, so the project is expected to be profitable. A worthwile investment 😸!
The calculation tool for NPV is available here.
Internal rate of return (IRR) also relies on the formula for NPV but answers different question. NPV tells whether a project is profitable but IRR tells what is the return rate of the project. The IRR is the discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. IRR uses the same formula as NPV, but sets NPV to zero and solve for the discount rate. The IRR is the rate at which the project breaks even. The formula for IRR is:
\[ 0 = NPV = CF_0 + {CF_1 \over {\left(1+IRR\right)^1} } + {CF_2 \over {\left(1+IRR\right)^2} } + {CF_3 \over {\left(1+IRR\right)^3} } + ... + {CF_n \over {\left(1+IRR\right)^n} } \tag{2}\label{eq2} \]where
A basic IRR calculation example: Company ABC invested a three-year project with an initial investment of $200k and a cost of capital of 10%. The return in next 3 years expected will be $80k, $80k, and $120k. The IRR of the project is calculated as follows:
\[ 0 = -200k + {80k \over (1+IRR)^1} + {80k \over (1+IRR)^2} + {120k \over (1+IRR)^3} \]The equation is sovled using Newton-Raphson Method and the calculated IRR is 17.5%. The IRR is higher than the cost of capital 10%, so the project is expected to be profitable. A worthwile investment 😸!
The calculation tool for NPV is available here.
The payback period is the amount of time required for an investment to generate cash flows sufficient to recover the initial cost of the investment. The payback period is a simple way to evaluate the risk of an investment without considering the time value of money. The payback period is calculated as follows:
\[ Payback \ Period = {Year \ before \ Break-Even} + { {Unrecovered \ Amount} \over {Cash \ Flow \ in \ Recovery \ Year} } \tag{3}\label{eq3} \]A basic payback calculation example: Company ABC invested a three-year project with an initial investment of $200k and a cost of capital of 10%. The return in next 3 years expected will be $80k, $80k, and $120k. The payback period of the project is calculated as follows:
The break-even year is year 3 since total recovered amount is $80k + $80k + $120k = $280k, which is more than the initial cost of the investment of $200k. The unrecovered amount at year 2 (year before break-even) is $200k - $80k - $80k = $40k. The cash flow in recovery year (year 3) is $120k. The payback period is 2 + $40k / $120k = 2.33 years. The project is expected to break-even in 2.33 years.
The calculation tool for payback period is available here.
In IRR formula \eqref{eq2}, all future cash inflows are reinvested at the same rate of return as the IRR itself, which is optimistic. However, in reality, the cash inflows may be reinvested at the cost of capital. The formula for MIRR of a project with multiple cash inflows is shown below:
\[FV_n = CF_1 \left(1+r\right)^{(n-1)} + CF_2 \left(1+r\right)^{(n-2)} + CF_3 \left(1+r\right)^{(n-3)} + ... + CF_n \tag{4a}\label{eq4a} \] \[MIRR = \sqrt[n]{FV_n \over CF_0} - 1 \tag{4b}\label{eq4b} \]where
All future cash inflows are reinvested at the cost of capital and converted to future value at time period n \eqref{eq4a}. The future value of cash inflows is compared to the initial cash outflow to get the MIRR \eqref{eq4b}.
A basic MIRR calculation example: Company ABC invested a three-year project with an initial investment of $200k and a cost of capital of 10%. The return in next 3 years expected will be $80k, $80k, and $120k. The MIRR of the project is calculated as follows:
\[ FV_3 = {80k (1+10\%)^2} + {80k (1+10\%)^1} + {120k } = 304.8k \] \[ MIRR = \sqrt[3]{304.8k / 200k} - 1 = 15.08\% \]MIRR gives a relatively lower but probably more realistic rate than IRR. The calculation tool for MIRR is available here.
A sensitivity study is conducted to show how NPV varies with the discount rate. The sensitivity study is a useful tool to evaluate the risk of an investment. The sensitivity for NPV is available here.