How to assess a project's financial viability

Let’s suppose a cable & internet company wants to manufacture its own tablet PC. The company wants first to manufacture a WIFI only device to test the market, and then a 3G device. The company is not sure to undertake the project as it will not bring 3G revenue, so it first wants to figure out if the Wifi project is profitable.

In order to assess the project, we will consider the following hypothesis:

• The tablet is sold $300 the first 2 years, and $250, the next 3 years. The gross margin is 60%, which makes an operating cost of $180 for the first two years, and $150 for the next three years.

• On year 1 and 5, the product manager thinks 750,000 units will be sold. On year 2,3 and 4, it is believed that 1,000,000 units will be sold.

• The project requires a working capital of $50m, which will be recoverable at termination.

• The project requires an initial investment of $300m for plant and manufacturing equipment. It will be fully depreciated at the end of the project.

• The tax rate is 35%.

Hypothesis parameters have been put in the table below:

To Assess the project, we use the Net Present Value method (NPV). This method consists in calculating cash flows generated by the project, year over year and discount them by an appropriate rate. If the sum of the discounted cash flows (=Net Present Value) is positive, then the project could be undertaken. On the contrary, negative NPV means the project is not financially worthwhile.

Let's see how to calculate annual cash flows:
With no tax, Cash Flow = (Sales – Costs) - Change in Working Capital - Investment

With Tax, calculating cash flows is a little more complicated. A tax rate t will actually be applied to the EBIT (Earnings Before Interest and Tax) where:

EBIT = EBITDA – Depreciation & Amortization,

and EBITDA (Earnings Before Interest, Tax, Depreciation & Amortization) = Sales – Costs


Then Cash Flows =  EBITDA (or Sales – Costs) - Change in Working Capital – Investment - EBIT x t


As EBITDA = EBIT + Depreciation, therefore:

Cash Flow = EBIT + Depreciation - Change in Working Capital – Investment - EBIT x t

Then:
Cash Flows = EBIT (1-t) + Depreciation - Change in Working Capital – Investment

Coming back to our example, let’s first calculate EBIT, then Cash flows, year over year with a tax rate t = 35%.

This gives the table below (in k$):

We now need to discount cash flows by an appropriate discount rate. This could be a bit tricky. The rate which is used to discount the cash flows is the WACC (Weighted Average Cost of Capital). WACC is the weighted average of the cost of equity and the cost of debt (remember company funding relies both on equity (capital) and debt (banks). The cost of debt is cheaper than the cost of equity, but a company should avoid too much debt as it is a cause of bankruptcy.

WACC is calculated thanks to the Capital Asset Pricing Model (CAPM), which is based in the relationship between risk and return. We will not discuss any further in this post about this concept. For our example, we will use a discount rate r of 9%.

To calculate discounted cash flows, we use the formula:
Discounted Cash Flows(n) = Cash Flows(n) / (1+r)^n where n represents the year.

Discounted Cash flows are in the table below (in k$):

Then, Net Present Value NPV = ∑(Discounted Cash Flows).

So, we find: NPV = $11,424k with r = 9%.

NPV is positive, so the project is worthwhile.

However, if we had used a discount rate of 12%, NPV would have been negative, and the project could not be undertaken. Because NPV depends on the discount rate, the Internal Rate of Return (IRR) might help to assess the project.

IRR is the discount rate for which NPV = 0. If we are not sure of the discount rate, but if we think it is less than the IRR, then the project can be undertaken, as it is shown below.

In our example, IRR= 10.2%. If we are confident the discount rate is below 10.2%, then the project can be undertaken.

Another method of assessing a project is the Payback period. The payback period is the period of time required for the return on an investment to "repay" the sum of the original investment. Contrary to the NPV method, the time value of money is not taken into account. Payback period is however widely used due to its ease of use.

To conclude, the best way to assess a project is to calculate its Net Present Value (NPV). To do so, we need first to calculate cash flows generated by the project year over year. Cash Flows are calculated thanks to this formula:

Cash Flows = EBIT (1-t) + Depreciation - Change in Working Capital – Investment

Then, Cash Flows are discounted with an appropriate rate, which gives the Net Present Value (NPV). If NPV is positive, the project is worthwhile and can be undertaken. If we are not sure of which rate to use, the Internal Rate of Return (IRR) might be calculated and compared to the discount rate.

Finally, if NPV gives a good indicator to assess a project, other factors should be considered to undertake a project. Indeed, in our project (PC tablet), there can already exist a strong competition with better products, or the distribution networks are not sufficiently developed, or it is too difficult to maintain a tablet product line as a cable company. All these factors might undermine the project even though NPV is positive...