Tag: Project Management

Click here to read Part 1  and Part 3 of this 3 part Series.

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

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

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%).

Capital Structure

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.

Click here to read Part 2 and Part 3 of this 3 part Series.

Abstract: Projects are financial and strategic investments that exist to deliver value.Cash flow modeling is a required and essential step to produce return on investment (ROI) financial measurements that support the project selection process. Examined here are finance topics, specifically six key questions (Number 1 and 2 below) non-financial personnel need answered at the onset of the process to assist in producing reliable and accurate cash flow models to transform the project manager into a strategic value-enabler and profit creator.

Projects are financial and strategic investments initiated to improve shareholder value and are only successful when they deliver their expected business returns. Senior leaders – the executives above the project level – realize this, think in these business terms, and crave financial information for decision purposes. To be a strategic value-enabler and profit creator, a project manager must be capable of conveying the big picture of their projects in both business and financial terms. Developing these skills will enhance your ability to manage the delivery of value.

Let’s begin with a hypothetical business scenario. You’re working on a significant project. It’s one-third complete. The company hires a new CFO, and in an effort to get up to speed quickly, a meeting is called. You are asked to review the potential project results because the investment required for this particular project is quite large. Are you prepared to discuss your project’s ROI financial measurements (e.g., ROI, IRR, NPV, Payback) or will you freeze like a deer in the headlights? Did you prepare a cash flow model that summarizes your project’s financial value to the organization – financial projections that your superiors are likely to take seriously? Without this knowledge, how do you really know if you are using corporate funds and resources wisely?

Project professionals are quite proficient at managing project management’s triple constraints – scope, cost and schedule – yet they often fail to grasp the big picture. Often the thrust of their efforts is on project execution, when it should be (more appropriately so) on value attainment. By sharpening your understanding of basic financial concepts, you can greatly improve your ability to project and articulate project benefits in quantifiable business returns.

If your project is not in alignment with the organization’s financial and strategic goals, simply ask yourself: why bother? For this reason, the knowledge and skills needed to quantify projected returns are imperative for any successful project manager. This article aims to acquaint project managers with the information and knowledge required in advance of efforts to build a cash flow model. The intent is to increase comprehension and make developing models a lot less arduous, eliminating many of those “I don’t know how to proceed” roadblocks. Armed with this knowledge, you will be one step closer to producing an accurate financial representation of your project.

You will need to know the following:

What is the accounting method used for depreciating assets?

To calculate key financial measures needed to assess a project’s value contribution requires that you identify project assets and determine if, and how, they should be depreciated. To account for depreciation, a well-developed financial model must reflect depreciation expenses for assets purchased/placed in service by the project.

Generally accepted accounting principles (GAAP), which vary from country to country, represents the standard in the United States for creating financial reports. The standards require that the value of an asset be expensed or “allocated” over the useful life of the asset (i.e., over the time that it is used to generate revenue and profits) according to “The Matching Principle,” which essentially allows for a more objective analysis of profitability.

The Matching Principle is a fundamental accounting rule in which the income or revenue (cash inflows) match up with associated expenses (cash outflows) to determine profits in a given period of time – usually a month, quarter or year. In other words, cost is recognized (for accounting purposes) at the time when the benefit that the cost provides occurs. This differs from when the actual expense occurs during project execution. The theory surrounding this is simple. For example, if your project requires the purchase of a specialized piece of equipment, which is expected to generate revenues over the coming five years, it makes sense to allocate (match) via a depreciation schedule, the purchase cost of the equipment over the given time period it is expected to produce revenue. Done differently, the numbers on the organization’s income statement could result in misleading or false conclusions.

There are different accounting methods an organization can use to depreciate assets. The more common methods include straight-line, fixed percentage, and declining balance, with straight-line being the most common and the easiest-to-use method. With straight-line, the original asset cost, less its salvage value (at the end of its useful life) is expensed in equal increments over its depreciable period. An asset may or may not have an estimated salvage value at the end of its useful life. For example, a depreciation expense of $12,000 per year ($1,000/month) for 5 years using straight-line depreciation may be recognized for an asset that costs $60,000 with no salvage value at project completion. The depreciation expense becomes a write off (over the asset’s anticipated life) against profits in the same period.

Depreciable assets include equipment and other tangible assets. Computing depreciation may vary according to the asset class, accounting standards, length of the depreciable lives of the assets, or the tax laws of a particular country. Supplies and other such items to be used within one single year cannot be depreciated and are expensed during that year.

The ability to expense an asset is useful for tax purposes. Generally, the cost is allocated as depreciation expense. Depreciation is a noncash expense, therefore reducing the total tax liability for the proposed project. Obviously, this is a good thing, since depreciation lowers reported earnings while increasing free cash flow.

What is your company’s income tax rate?

Taxes are a real expense, have a significant impact on project results, and consequently lower overall financial benefits that projects achieve. For this reason, cash flow models are built on an after-tax basis. After-tax cash calculations are needed to discount future payoffs (future cash inflows) to present values, which in turn provide the means to calculate additional metrics you will require.

If your firm’s tax rate is 30%, a $350,000 operating gain generated by a project becomes $245,000 once taxes are taken out. However, if that income tax rate was 35%, the $350,000 financial gain then becomes only $227,500 ($17,500 difference no longer contributing to bottom line results). There may be time-period(s) when the project loses money, in which case the appropriate tax rate is applied to the operating loss, thus lowering the tax liability. Reflecting the impact of taxes produces ROI financial measurements that are more precise. You will therefore want to know your firm’s tax rate.

Keep and eye out for Part 2, to be published August 8th.