Investment Decisions – Capital Budgeting

One of the things I find fascinating is the tendency for economic development organizations to focus so much time and attention at creating a financial incentive package for potential capital investors and not spend hardly any time monitoring whether the project gets started on time or not. Yet, the cost of a delay can result in a significant loss of revenue for a company.

Net Present Value (NPV)

NPV is used by most companies in capital budgeting to analyze the profitability of an investment. It is a calculation that compares the value of a dollar today to that same dollar in the future. In principle, if an NPV is positive the investment makes sense, if it is negative it is a bad financial risk. The discount rate used in the calculation reflects an assumption of the interest rate a company could get on the money if invested elsewhere.

What Is The Cost of a Delay?

Let’s look at a case where the Ajax Company is looking to build a new manufacturing facility. Management has decided this is in the strategic best interest of the company. They have reflected this decision in a forward-looking P&L statement that forecasts a 10-year net revenue stream.  For the sake of simplicity, let’s assume it will cost $1,200,000 to build the plant and it will take 12-months. We’ll further assume the revenue stream projection of $2,400,000 in year 2, $3,600,000 in year 3, $4,800,000 in year 4 and $6,000,000 in years 5 through 10. Management sets the discount rate at 10%.

The NPV for this project is $24,723,969, and Management has that return already built into their 10-year financial forecast.

But, what if problems in processing paperwork or getting the required infrastructure in place cause a 2-moth delay? What does that cost the Ajax Company?

First, look at the impact on the net revenue stream created by the delay. You can see that it take the Ajax Company until Year 6 of the project to before the annual net revenue stream no longer reflects the loss of $200,000.

Second, let’s look at the impact on the project NPV since this is one of the values the CFO will be evaluating. The NPV for this new revenue stream is $23,982,341. To the Ajax Company, that is a difference of $741,628.

AJAX COMPANY – ON TIME PROJECT versus 2-MONTH DELAY

Discount rate = 10%, Initial Cost = $0

On Time NPV = $24,723,969

2 Months Late NPV = $23,982,341

Difference = $741,628

Discussion

The Ajax Company example is an over simplified on for illustration purposes only. The NPV was calculated using the Investopedia Net Present Value Calculator. The Project Life was input as 10-years and the Initial Cost was input as $0. I reflected the $1,200,000 cost of the project as the net Year 1 revenue. To determine the revenue stream for a 2-month delay I simply shifted the monthly revenue by 2-months (month 1 and 2 of year 2 had a value of 0).

The purpose of the Ajax Company example was to demonstrate that even seemingly small delays in a project potentially has a big impact on the value of the project to a Company. Ajax Management would be stuck with having to find a way to either make up that $741,628 in value or lower their forecast. Neither is a particularly fun exercise.

Now imagine a scenario where your EDO guarantees on time execution of those aspects of a capital investment project that are under your control. In the Ajax Company case you would be able to say that the risk of selecting another location that doesn’t offer a similar guarantee and subsequently experiencing a 2-month delay is $741,629. Of course, the value of that guarantee grows with every possible month delay.

Additional Links

http://www.fao.org/docrep/W4343E/w4343e07.htm

http://en.wikipedia.org/wiki/Corporate_finance

http://www.slideshare.net/parksiteat/chapter-10-the-fundamentals-of-capital-budgeting

What is Your Experience?

I would really love to have readers with Finance experience add their perspective to this post. The better everybody understands how a CFO evaluates capital investment projects, the better prepared we will all be to meet their needs.

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