6 Questions on the Path to Financially Justified Projects: Developing Cash Flow Models – Part 2
What is the payback period?
Payback period, also known as time-to-money period, is a measure of risk and more aligned with organizational liquidity than anything else. The longer the payback period, the riskier the project becomes. A risk averse company may have a smaller payback period stipulation, perhaps a cutoff period of less than two years, than one more tolerant and open to more risk.
If your company has established risk tolerance parameters around payback periods, you will want to know this. Your project may be cut off from further analysis before it even gets off the ground.
What determines whether a given cost is a “capital expenditure” or an “operating expense”?
Most capital expenditures are depreciable assets, while operating expenses are not. The difference and the relevance to your project is this: operating expenses directly reduce profit by showing up on your project’s income (cash flow) statement. Whereas with capital equipment, only the depreciation appears on the income statement and the capital expenditure (the large layout of cash) shows up on the balance sheet.
Organizations generally consider an asset as depreciable if it is greater than a specified dollar amount. Submitting project financials that align with company policy is the reason why you will want to address this question.
Do you know your company’s weighted average cost of capital (WACC)?
Ever get curious about where the money comes from to fund projects once approved? Companies fund projects (and other areas of the business) by one of two primary means: debt and equity, or a combination of both. Let’s explore debt and equity first, as this will help solidify your understanding and comprehension of the financial metric introduced in the above subtitle.
Debt is borrowed money. Financial institutions (the most common debt financing source) lend companies the money that often finances projects. The loan(s) could be in the form of a revolving credit line or issued as a direct loan(s). Companies incur interest rate charges on the various loans they acquire and/or the corporate bonds they issue. The interest rate may vary across the various sources of these funds. The average of these rates is the “blended rate.” This blended (interest) rate represents the “cost of debt” to the company expressed as a percentage.
Equity represents another source (and more costly form) to fund projects and business operations. Corporations can secure funds by selling stock (or by utilizing retained earnings from business operations, another form of equity). In return for their investment dollars, shareholders receive ownership interest in the company, but they also expect a reasonable (or better) financial return on their investment (e.g., stock price appreciation, dividend payouts). Company directors may know that if the company provides an overall annual return to investors (of some amount, let’s say 8%) they are likely to remain happy and stay as investors. Companies must meet the financial expectation of shareholders; otherwise they could sell their shares, causing the stock price to drop. This is the “cost of equity” (also expressed as a percentage) and is essentially what it costs the company to maintain a share price theoretically acceptable to investors (e.g., the 8%).
For reasons not relevant here, some businesses find that it makes more sense to purchase items by incurring debt (bank loans), and for others, to use cash (equity financing, selling stock). The balance between debt and equity funding signifies the company’s capital structure; it represents the percentage of debt and percentage of equity a company maintains to fund its projects and run day-to-day business operations. Capital structure can vary greatly from one company to another or from one industry to another (e.g., 30% debt to 70% equity structure for one company and 50% debt to 50% equity structure for another, or variations thereof).
Weighted Average Cost of Capital and its Relevance
We are now ready to explore the financial metric called weighted average cost of capital, referenced earlier as WACC, which is a measurement that refers to the capital structure of a company. It is a proportionately weighted calculation that brings together the weighted cost of debt and the weighted cost of capital (into one number) used to express an overall interest rate for a company to meet its obligations to financial institutions and shareholders. For example, WACC = 14.75%.
A specific company may have a 30% debt capitalization at 8.2% (the blended interest rate) and a 70% equity capitalization at 14% (rate shareholders kept happy, remain as investors). It is from these numbers that the WACC is derived. Note: The required rate of return on debt is after tax.
Keep in mind, WACC is also descriptive of company risk (not to be confused with project risk), as smaller firms are less likely to secure the same debt financing terms (i.e., the lowest possible rates), as larger and perhaps more creditworthy organizations. The business reality of higher opportunity costs (higher risk) reflects in the blended (debt) rate and in stockholders’ higher requirements, and then finally in the WACC calculation itself. Stable companies (e.g. Walmart) will have a lower WACC representative of lower risk, and therefore a lower hurdle rate to jump over when approving projects.
Perhaps we have arrived at the “Ah ha” moment, understanding the relevance of WACC to the project manager. When developing a discounted cash flow valuation model, WACC is used as a discount rate to derive a project’s net present value (NPV). NPV conveys the financial value a project brings to the organization in today’s dollars from the anticipated future cash flows. If the borrowing rate is 14.75%, the project submitted for approval must have a yield greater than this for it to be profitable. The project’s financial return or internal rate of return (IRR) must be greater than the money being borrowed to fund the project.
Keep and eye out for Part 3, to be published August 15th.