Owners and managers face many tough questions in the normal course of operating a business. Should I expand into new product lines or geographic markets? Can I afford to buy a cutting-edge piece of equipment? Does it make sense to build this component in-house or to outsource its production? Which investment alternative will give me the greatest return?
For most day-to-day decisions, managers only have time to make rapid choices based on experience and acumen in business matters. But as the dollars at stake grow to tens or hundreds of thousands, so will sleepless nights if managers base strategic decisions solely on those factors. For big-ticket items—and greater peace of mind—managers often turn to feasibility studies.
Case in Point
To illustrate how feasibility studies can facilitate management’s decision-making process, consider the fictitious example of Dom’s Tool & Die Co. Dom’s operations manager recently suggested that his tool-and-die shop could win several large jobs from a nearby competitor if the company purchased a $1 million state-of-the-art piece of machinery.
Initially, Dom was skeptical. Although the purchase made sense from a selling and operations perspective, Dom wanted to make sure the decision was also evaluated from a financial perspective. Three easy-to-understand financial metrics are used by financial experts that would help Dom with his decision: payback period, net present value and internal rate of return.
Payback Period
The Payback Period is defined as the length of time required to recover an initial investment. The shorter the time period, the better the investment opportunity (since the initial investment is recovered sooner).
In this case, it was determined that Dom’s Tool & Die will have to wait four years to recoup its initial investment.
Though some managers rely exclusively on the payback period to gauge an investment’s viability, the payback period does have its limitations. Payback period analysis does not address the time value of money (by considering the risk of the cash flows being generated), nor does it go beyond the recovery of the initial investment. For these reasons, the payback period methodology is more appropriate to situations when projects have similar time span characteristics and similar risks.
Net Present Value
The Net Present Value (NPV) of a project or investment is defined as the sum of the present values of the annual cash flows minus the initial investment. It is used to determine whether there is a net gain to the project given the risks and time horizon. The annual cash flows are the revenues minus costs generated from the investment during its lifetime. These cash flows are discounted or adjusted by incorporating inflation (time value of money) and the perceived risks of the investment.
An expanded version of NPV, known as Monte Carlo analysis, provides a deeper understanding of the relationship between the assumptions and the final NPV value. Monte Carlo analysis goes further in that it provides more than a single-point estimate of NPV; instead, it produces probabilities of achieving certain results which enables managers to better gauge the sensitivity of the assumptions being used.
Dom’s advisors estimated the tool-and-die shop’s project NPV at approximately $50,000. Since the NPV was greater than zero, the investment made financial sense.
Internal Rate of Return
Finally, IRR estimates an investment’s yield over its useful life. It is also the point at which the investment’s NPV is zero. In evaluating this metric, many managers will compare the yield to a subjective “hurdle rate,” which is the minimum rate of return management requires before it will accept a project. Frequently, management uses a company’s cost of capital as the hurdle rate that a project must clear for acceptance. If the IRR is greater than management’s predetermined hurdle rate, the investment makes financial sense.
Using IRR simplifies the process of estimating the value derived from a project as compared to the NPV calculation. The IRR method does not require establishing the discount rate, which can be a difficult task when including the unique risks of the project. The IRR, however, is just the flip side of NPV and is based on the same principles and calculations.
Back to our example, the IRR for the project was calculated at 12 percent. Dom compared this to his hurdle rate or required rate of return in evaluating the project. When Dom and his management team finally decided to purchase the new machine, they were confident that they had evaluated all of the relevant information and that their choice was the right one.
Drawing Conclusions
Most savvy managers are aware that no decision should be made based solely on financial reasons. But often times the process of determining and understanding the assumptions that drive the financial projections provide valuable insight into the merits of the actual business decision being made.
If your company needs assistance in performing such analysis, look for more than a traditional accountant, who primarily focuses on the latest accounting standards and IRS codes. Consultants, such as business valuation specialists, are more comfortable with discounted cash flow techniques, as well as how to construct malleable, interactive spreadsheets.
Seek professionals who desire to understand the business behind the numbers. The reality is that spreadsheets and statistics can be used to make almost any proposal feasible, depending on the assumptions used. It is the professional who goes beyond the numbers and provides objective business insight that proves to be valuable in the strategic decision-making process. IBI
