Investment project valuation model

From the technical standpoint, your investment project valuation model is – like financial valuation model for a business entity – a Microsoft Excel workbook (few investment professionals are using Open Office or Google Sheets).

The core of this workbook is the worksheet that calculates the KPI for your investment project: Gross Cash Flow, Free Cash Flow, Total Investment, Breakeven Point (if applicable), Payback Period, Net Present Value (financial value generated by your project) and Internal Rate of Return (IRR or MIRR) and economic profit.

A separate sheet is used to calculated project discount rate – which is usually your corporate WACC adjusted for additional project-specific risks. Adjustment is made, obviously, by analyzing your corporate risks using your corporate risks measurement and management system that I cover in the corresponding section of this guide.

Let’s define properly all these KPI.

·         Gross Cash Flow is the cash flow generated by operational component of your project – without taking into account the financing part – increase in working capital and capex

·         Free Cash Flow (FCF) is the cash flow generated by your project after you make all necessary investment in your working capital and capex

·         Total Investment.  This is essentially the sum of all of your negative FCF, which shows how much money needs to be invested into your project before it starts making money

·         Breakeven Point. It is the point in time when your FCF turns from negative to zero. Which means that your project can now support itself and needs no more cash infusions

·         Payback period.   It is the time period measured in days, weeks, months or years that tells when you will get all your investment back. In other words, how long it will take for your project to generate the amount of cash equal to your total investment.

·         Net Present Value (NPV). This is the sum of all cash flows (both positive and negative) generated (or consumed, if they are negative) discounted at your project’s discount rate (which usually is your corporate WACC adjusted for additional risks of your project)

·         Internal Rate of Return (IRR). It is the discount rate of your project that makes your NPV equal to zero. Which means that your investment breaks even. In other words, the IRR of the project is the discount rate at which the net present value of negative cash flows of your project equals the net present value of its positive cash flows

·         Economic Profit. It is simply the difference between IRR and the discount rate. Which must be positive for your project to make economic sense and thus to be accepted.

IRR calculation formula has some inherent problems, too technical for this guide. Specifically, more than one IRR can be found for projects with alternating positive and negative cash flows, which leads to confusion and ambiguity. MIRR finds only one value.

Therefore, most practical calculations used the modified IRR (MIRR) as the replacement for the original IRR. Replacement that resolves these problems.

All other worksheets in your project financial model workbook are used to support this core and contain historic (if applicable), planned and actual values of items used to calculate your KPI:

·         Revenues generated by your project (either direct or via cost savings)

·         Variable costs directly traceable to these revenues

·         Fixed costs that need to be properly allocated to your project using the optimal cost accounting methodology

·         Depreciation & Amortization expenses (a non-cash charge which need to be added back to calculate your Gross Cash flows from the project in question)

·         Your effective tax rate on profits (net income) generated by your project

·         Increase in working capital required by your project.

·         Capex – capital expenditures on purchase, leasing or upgrade of long-term operating assets which (1) are required by your project and (2) will be retired after this project is completed. Net of the residual price that you can get if you sell – rather than simply discard – these assets.

Any investment project is usually implemented in four steps:

1.      Initiation. Which requires the ‘project sponsor’ (the manager or specialist initiating the project) to complete three basic components of initial project description: financial plan (which is the same thing as project valuation model), operational plan (system of activities that will lead to achieving the financial objectives of the project in question) and the business plan, which describes in detail, how your project will generate financial value for your company. The latter document – which must be supported by all relevant corporate documentation – is often called the ‘IRACORACI report’. IRACORACI stands for Increase Revenues, Avoid Costs, Optimize Risks, and/or avoid Capital Increase (meaning increase in working capital or capex caused by increase in sales).  

2.      Pre-implementation evaluation. At this stage the project is evaluated to make sure that its KPI – calculated at the initiation stage – are (a) accurate; (b) achievable and (c) meet the capital budgeting (investment) requirements of your company.

3.      Implementation proper. If your project is accepted for implementation, it needs to be, well… implemented. The issue here is that your corporate environment is subject to a rapid - and often significant – change, you will have to make some changes to your operational and possibly even financial plans. However, you must make only those changes that will change the means to achieve your financial objectives, not your objectives. And if you change them, you only improve them, capitalizing on opportunities offered by changes in your corporate environment. To make it possible, you must learn to view even threats as ‘opportunities in disguise’.

4.      Post-implementation evaluation. At this stage you compare actual KPI values with planned and do ‘ACRC’ – Analysis, Conclusions, Recommendations for initiating, evaluating and implementing future projects accompanied by all necessary Comments