six questions on the path to financially justified projects

8/20/2019 Six Questions on the Path to Financially Justified Projects

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PMI Virtual Library

© 2014 Bill Kay

Six Questions on the Path to Financially

Justifed Projects: Developing Cash Flow

Models

P

rojects are financial and strategic investments initiated

to improve shareholder value and can only be

successful when they deliver their expected businessreturns. Senior leaders, the executives above the project level

realize this, think in these business terms, and crave financial

information for decision purposes. o be a strategic value-

enabler and profit creator a project manager must be capable

of conveying the big picture of their projects in 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 big project. It’s one-third complete. Te

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 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?

By Bill Kay, MSOL, PMP

AbstractProjects 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

are finance topics, specifically six key questions non-financial personnel need answered at the onset of the process if they

are to produce reliable and accurate cash flow models to transform the project manager into a strategic value-enabler and

profit creator.



PMI Virtual Library | www.PMI.org | © 2014 Bill Kay

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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’sfinancial and strategic goals, simply stated: why bother? For

this reason, the knowledge and skills needed to quantify

projected returns are imperative for any successful project

manager. Tis article aims to acquaint project managers

with the information and knowledge required initially, and

in advance of, efforts to build a cash flow model. Te 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?

o 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. o

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. Te standards

require that the value of an asset be expensed “allocated”, over

the useful life of the asset (i.e., over the time that it is used

to generate revenue and profits) according to “Te Matching

Principle,” which essentially allows for a more objective

analysis of profitability.

Te Matching Principle is a fundamental accounting

rule in which the income or revenue (cash inflows) match

up with associated expenses (cash outflows) to determineprofits 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. Tis differs from when the actual expense occurs

during project execution. Te 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.

Tere are different accounting methods an organization

can use to depreciate assets. Te 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. Assets 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. Te 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 considered to be used within

one single year cannot be depreciated, and are expensed

during that year.

Te ability to expense an asset is useful for tax purposes.

Generally, the cost is allocated as depreciation expense.

Depreciation is a noncash expense and therefore reduces the

total tax liability for the proposed project. Obviously, this is agood thing, since depreciation lowers reported earnings while

increasing free cash flow.

What is your company’s income tax rate?

axes 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’ll 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).

Tere may be time-period(s) when the project loses money, in

which case the appropriate tax rate is applied to the operating




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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.

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. Te longer the payback period, the riskier

the project becomes. A risk adverse company may have asmaller 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”?

Capital expenditures (most) are depreciable assets, andoperating expenses are not. Te difference, 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, the capital expenditure (the large

layout of cash) shows up on the balance sheet.

Organizations generally consider an asset 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.

DebtDebt is borrowed money. Financial institutions (the most

common debt financing source) lend companies the money

that often finances projects. Te 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. Te

interest rate may vary across the various sources of these

funds. Te average of these rates is the ‘blended rate.’ Tis

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 returnfor 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 to stay as investors. Companies must meet

the financial expectation of shareholders; otherwise, they will

unload their shares, causing the stock price to drop. Tis is

the “cost of equity” (also expressed as a percentage), and is

essentially what it costs the company to maintain a share pricetheoretically 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). Te balance between debt and equity funding signifie

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 orfrom 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. WACC 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 acompany 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 the WACC is derived.

Note: Te required rate of return on debt is after tax.




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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. Te 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, for example

Walmart, will have a lower WACC representative of lowerrisk 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. Te project’s financialreturn or internal rate of return (IRR) must be greater than

the money being borrowed to fund the project.

What is the hurdle rate your company uses?

No company has an unlimited source of funds from

which to execute its strategy. It stands to reason that with

limited funds available, those projects funneled through the

selection criteria must be profitable if the organization is to

achieve its intended strategy. Tis limitation imposes upon

the organization the need to make thoughtful, calculated

decisions concerning what projects receive funding approval. A key component of this decision process is a company’s

selection of their expected/required rate of return, or the

“hurdle rate” that must be achieved to make projects a

worthwhile investment in their particular business setting.

o make it worthwhile, project investment returns

always need to be higher than the cost of capital. Te WACC

(percentage) represents the cost of capital, and is used (most

often) as the hurdle rate, but not always. If used as the

hurdle rate to make and evaluate investment decisions, the

WACC would represent the minimum required rate-of-return

at which a company produces value for its investors. Te WACC is appropriately used as the hurdle rate if you are

confident the promised future cash flows will be received.

Many finance professionals assume that the historical

WACC is automatically the correct discount rate with which

to assess a prospective project’s NPV. Tis assumption is

incorrect; the company’s WACC should not extend to all

projects. What matters most is the relative risk profile of the

specific project under consideration, and its ability to generate

net free cash flow that is certain. While risky projects may

provide leapfrog advantages to an organization, overall risk

increases and financial certainty fades, as future cash flow

estimates are likely to be flawed (e.g. high probability of cost

overruns). When project risk is higher than the company’s

existing complement of average or typical undertakings asreflected in its historical WACC, a project risk premium

should be added to the company’s cost of capital. Tis

provides a hurdle rate equal to the company’s cost of capital

plus the project’s risk premium.

Tis protective measure employed by the company

compensates for accepting the added risk by requiring a risk-

adjusted rate of return. Te profitability expressed by the NPV

calculation is lowered and the chance of accepting the project

is also lowered. Evaluating alternatives by requiring a higher

rate tilts results in favor of selecting profitable projects, while

eliminating from consideration marginally profitable projects.Te inevitable tradeoff here is between realizing an ‘opportunity

loss’ versus realizing a ‘real loss.’ In the latter situation, there is

a real economic loss and the company is shedding value.

Risk premiums can vary from less than one percent

to several percentage points; and inversely, especially-low-

risk projects may warrant a downward adjustment in the

WACC to account for the risk differential. Establishing

the hurdle rate(s) has more to do with careful reflection

and forward-looking vision than a finance department

formula. Influencing factors, assumptions, or judgments

might include the economic horizon, competitive forces,industry conditions, type of financing anticipated, risk

tolerance (obviously a major factor), faith in the accuracy of

the estimates, and the company’s overall situation (e.g., cash

position/liquidly).

Conclusion

Always consult your finance department or CFO on these

important questions and any appropriate method(s) or

guidelines specified within your organization. Armed with

this knowledge, you are likely to build cash flow models your

superiors will take seriously. Furthermore, it will demonstrateunderstanding and show initiative on your behalf and you wil

likely earn considerable credibility with that department (or

other key decision makers) which incidentally, may ultimately

have final word, or control the purse strings on your current

(or future) project.




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Works Consulted

Berman, K., Knight, J. & Case, J. (2006). Financialintelligence: A manager’s guide to knowing what the numbersreally mean. Boston, MA: Harvard Business School

Publishing.

Callahan, K. R., Stetz, G. S., & Brooks, L. M. (2007).

Project management accounting: Budgeting, tracking, andreporting costs and profitability. Hoboken, NJ: John Wiley &

Sons, Inc.Resch, M. (2011). Strategic project management

transformation: Delivering maximum ROI & sustainablebusiness value. Fort Lauderdale, FL: J. Ross Publishing Inc.

About the Author

Bill Kay, MSOL, PMP, has 35 years of experience as an

entrepreneurial leader in operations, process re-engineering,

and project management. He is focused on solving business

challenges and identifying opportunities to increase a

company’s efficiency, organization, growth, and profitability.

Mr. Kay graduated with honors from Regis University’s

College of Professional Studies, Denver, Colorado, with

a Master of Science in Organization Leadership: ProjectLeadership and Management Degree, and a Graduate

Certificate in Strategic Business Management. He earned his

Bachelor’s degree from William Paterson University of New

Jersey. He is a Project Management Professional (PMP)®

credential holder and active member of PMI’s Atlanta

Chapter. His LinkedIn and Google profile can be viewed at

https://www.linkedin.com/in/billkay .

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