1.1 Project Parameters

1.2 Cash Flow

1.3 Profit & Loss

1.4

It should be noted that not only is the project short of (£50 m) cash to finance the project but also, (since the accountants have made a profit) needs £35 m cash to pay the taxman and a further £35 m has to be found to pay the shareholders a dividend.

1.5

Other costs can also be manipulated. On one occasion the head of the management school said to me: “Your MSc course never makes any profit.” Fortunately, I had my wits about me and responded with the fact that the school overheads would be virtually unchanged without my course and responded with: “It depends on how much overhead you want to load onto my course.” This scenario is valid for most business environments and is particularly true of manufacturing. In a project environment, the overhead will usually be fixed at an hourly rate right across the board. However, the amount held in reserve for various risks on a project can be adjusted as you wish.

1.6

Lenders of money will consider several factors, listed below, before cash is advanced:

1. Security If the project fails, will they still get their money back?
2. Inflation Will the return of the money cover for future inflation?
3. Timing When will the money be repaid?
4. Return Will there be a return over and above inflation to cover for the risk?
5. Opportunity Cost Would it be better to lend the money to another project?

1.7

Project appraisal usually involves looking at the returns of a project in terms of cash. Even if the project is being undertaken for other than financial reasons, the benefits are often given cash values and the scheme viewed exclusively from an accounting viewpoint. This system is called cost–benefit analysis. Projects usually involve the spending of cash now with a view to getting more cash back at a later date – see Figure V.G.1 which shows a typical cash curve for a project.

Figure V.G.1

2.1 Average Rate of Return on Investment

Here the cash flows are added up over the project life and an annual return calculated. This figure divided by the initial investment gives the average rate of return; see the tabulations below.

The average rate of return on investment (expressed as a percentage) tells us something about the profitability of a capital project. However, the averaging process eliminates relevant information about the timing of the cash flows.

In the second example Project D is preferable since the additional cash received in year 1 can be invested – there is an additional opportunity cost. However, the simple method of calculating the average rate of return on investment does not indicate this, and it ignores the timing of the returns.

3.1

Payback Periods for Project E and Project F (see next page.)

Figure V.G.2

4.1

Let us suppose that money can be invested today to yield 10 per cent a year; then £100 invested today will accumulate (compounding annually) to the amounts shown below:

• In 1 year's time, to £1 00 × 1. 1 0 = £100 × 1.100 = £110.00
• In 2 years' time, to £100 × (1.10)² = £100 × 1.210 = £121.00
• In 3 years' time, to £100 × (1.10)³ = £100 × 1.331 = £133.10.

* The end of Year 0 is ‘the present’ or simply, now.

4.2

What, then, is the present value of £100.00 to be received at the end of three years? Clearly it must be £75.13, as shown below:

We can prove this, by showing what would happen if we invested £75.13 at 10 per cent a year. Each year the effect of compound interest is to add 10 per cent of the start‐of‐year amount to the cumulative amount invested:

• After 1 year the amount becomes:   £75.13 + £7.51 = £ 82.64
• After 2 years the amount becomes: £82.64 + £8.27 = £ 90.91
• After 3 years the amount becomes: £90.91 + £9.09 = £100.00

Accordingly, the present value of £100 to be received at a future date is shown below:

4.3 Net Present Value – NPV

The net present value calculates a project's return by comparing cash payments and cash receipts at the same point in time by discounting future cash flows back to the present

Even ignoring inflation, £10 now is worth more than £10 in a year's time because of opportunity costs. Thus it can be seen that money has a time value, and this can be given a value by applying a discounting factor to the cash flows. The tabulations, in paragraphs 4.2 and 4.3 above, demonstrate this technique. The calculation of these discounted amounts can be done by use of standard discount tables (see Table A and Table B at the end of this section). Nowadays, however, most spreadsheet programs enable even very complex NPV calculations to be undertaken on personal computers.

4.4

If the discount factor used includes a figure for future inflation, then it is important to forecast the cash flows allowing for inflation. If the discount factor ignores inflation, then so, too, must the cash flows. The discount factor (sometimes called hurdle or criterion rate) is usually unique to each company or organization and is often updated each year. Its value depends upon a highly complex calculation, which establishes the company's cost of borrowing from banks, shareholders, and so on.

6.1

What is interesting is that changing the cost of design/engineering has minimal impact on the NPV of the project. Whereas, changing sales data for example, unit sales price, by say 5 or 10 per cent, has a very significant effect on the viability of the project. The salesperson shrugs their shoulders and says, ‘It is difficult to forecast the marketplace’ whilst the design manager could get the sack!

6.2

Whilst this plot is very useful, it does not show the likelihood of these assumptions actually changing. To overcome this problem, it is possible to give probability values to each assumption made and then summate all these probabilities to give an overall project plot.