How to Look at Growth Opportunities — April 2015

This topic involves financial management.

Capital allocation is the key responsibility for the officers of a firm, particularly the CEO. The CFO plays an integral part in the process by providing the tools to evaluate the capital allocation opportunities.

Investing in good projects is a key driver for profitable growth. The best managements have a robust framework that provides the tools to determine that the project is economically viable. The subsequent paragraphs describe the tools that can be used to develop this framework which is extremely helpful for thinking through the issues pertinent to the project and arriving at the best decision.

Evaluating a capital project is a four step process. First, forecast the cash flows assuming no interest payments are made. Second, assess the project’s risk. Third, determine the cost of capital based on that risk. Fourth, calculate the present value of these cash flows. If the present value is positive, the project is economically viable. Once undertaken, the project should be periodically re-evaluated.

To forecast the after tax cash flows, management must identify and quantify the prospective cash revenues and costs. Care must be taken to determine the amount and timing of these revenues and costs. The revenues should be calculated in quantifiable detail – for example, the number of products sold times the sales price. The timing should consider when the revenue is first generated (i.e. six months after the initial investment) and when the cash is collected (i.e. 45 days after the product is shipped).

The relevant costs include initial and subsequent investments to arrive at the production stage; costs of production; and costs of selling and administration. For each time period (normally each month) these costs are deducted from the associated revenue. The difference is then taxed and the result is the after tax cash flow.

The project risk is the return on investment required by investors and the company itself. For smaller , entrepreneurial companies this rate of return will be 15% or more. This is the cost of capital, which is then used to discount the cash flows (outlays and inflows) to derive a value known as net present value (NPV). This calculation is easily performed with Excel or another spreadsheet program.

Note that the discount rate reflects the cost of capital (required rate of return) for equity investors. It does not consider debt financing from banks or other lenders. This is a crucial approach known as separating the investment decision from the financing decision. Please see our Match 2015 post regarding the determination of how to optimally finance a projects. We suggest readers view the posts in conjunction with one another.

This approach allows management to focus on project cash flows rather than the cash flows associated with alternative financing schemes. As a result, managers are viewing whether the project has a positive NPV assuming all equity financing. If so, the project is economically viable. At this point, a separate analysis of the best financing strategy can be undertaken. Again, please see our March 2015 post.

The idea behind this approach is to establish a base case value, which is derived after the evaluation of a wide variety of assumptions and scenarios. Once a base value is established, management can then determine the value generated by various financing structures. The most common value provided is the tax benefits generated by tax deductible interest payments. Other effects include, issue costs such as points and fees (negative); subsidy packages from various government entities; and the flexibility to structure cash payments to accommodate the cash generated by the project.

Thus, the value of a given opportunity can be thought of as:

Base Case Value + Value of Financing Structure

Beware if the substantial majority of the project’s value derives from the financing structure. If this is the case, a thorough review of the project’s underlying assumptions is in order before proceeding with the project. Such an effort will force management to think through relevant business issues and avoid reaching for value due solely to the effects of financing.

Once the project is undertaken, it should be monitored to make sure it is achieving the anticipated benefits. It is virtually certain that problems will be identified and corrected, allowing the company to learn from its mistakes. Other outcomes include: expand the project if it is successful beyond initial expectations ; modify the project to adjust to unanticipated events; or abandon the project..

Investing in good projects is a key driver for company growth. The best managements have a robust framework that provides the tools to determine that the project is economically viable. The CFO plays an integral part in the process by providing the tools to evaluate the capital allocation opportunities. Investing in good projects is a key driver for profitable growth. The best managements have a robust framework that provides the tools to determine that the project is economically viable.

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