Welcome back. In this final module of the course. We'll begin building the business case or at least the financial analysis associated with the business case. We first take a look at what type of costs go into the financial analysis. Then in the next few lessons we'll put them into the forum the executive office expects to see in a project proposal. Are you ready? Then let's get started. This is perhaps the most practical module of the course as it ties together everything we've done so far. Until now we've been given values for the cash flow analysis or to calculate a project's net present value, the NPV, the internal rate of return, the IRR, and the payback period. But in reality you build the entire cash flow statement from scratch. And in this module, we'll see how to build the cash flow statement that will impress the C-Suite and make you the envy of your engineering colleagues. To begin with, let's define what we mean by a business case. A business case provides justification for a proposed project based on its commercial benefits to the business. Okay, that's easy enough. Here are all the elements that go into the business case. It always starts with an executive summary and your recommendations. This is the entire business proposal condensed into one page for those busy executives that don't have time to read the whole thing. Then comes the business drivers. These define the business opportunity and the market need. The proposal then talks about customers and markets, who is the customer and how many of them are out there. Then we finally get to the financial analysis which has many components to it such as the assumptions that you make, the cash flow statement, and the valuation where you show the NPV, IRR, and the payback period. There is a section on risk management incorporating a scenario and sensitivity analysis, something we cover in the third course in finance for technical managers. This section wraps up with a summary of all the costs and benefits, in essence the financial analysis section covers why the project makes great sense. Finally, the proposal concludes with the summary, your recommendation, and next steps. There is often an appendix or two where you would put all the details that you can't fit into the main body of the proposal. For this lesson and the ones that follow will focus on the financial section of the business case. For the entire course we've used the project's cash flows to determine the net project value, internal rate of return ,and the payback period. How do we get the right cash flows and which ones do we include in our analysis? The project's cash flows are determined by a combination of three elements, the after-tax cash flows coming from project operations, the cash flows required to stock inventory. So you have something to sell. Financially, this is referred to as the networking capital which we explore in the next lesson. Finally, we have the cash flows due to capital spending, meaning the CAPEX we've been talking about so far. The initial investment necessary to bring about all those financial benefits to the company. Once you have these final cash flows, we're ready for our NPV ,IRR, and Payback analyses. Now, let's get into some details, if you have a great idea for a very profitable project, what cash flows do you need for your financial evaluation? There are definitely some cash flows we take into account and some that we don't, and there are some cash flows that we might take into account. For example, you only consider the projects incremental cash flows. You never worry about the project sunk costs and you never account for any financing costs associated with the project. There could be some financial side effects both positive and negative and we might take these into account. The next few slides cover these in more detail. First, we only consider the projects incremental cash flows. Those are the financial impacts associated with your project, meaning you don't have to worry about every other aspect of your company's financials. By incremental cash flows, what we mean are the cash flows resulting from your project. Less the cash flows incurred today, or in other words the incremental cash flows are equal To-Be case minus the As-Is case. For instance, if you're proposing a process improvement project, then the To-Be case would be the cash flows by implementing the new process compared to the cost of how you're doing it today. The As-Is Case, on the other hand if you're proposing a brand new product and the As-Is cash flows are zero, as you're not offering the product today. Makes sense? Maybe the simplest explanation is this, the incremental cash flows are only those future cash flows that result from actually doing the project. And you never consider the sunk costs of a project only its future cash flows. And what do we mean by sunk costs? Those are the costs the company has already incurred all the money spent in the past to get to this point. Here's a typical example we all face, your team spent $2 million in R&D getting the technology right for a new product. Now, you want to advance the project to the commercialization phase. Do you consider the $2 million in R&D when evaluating the future project's net present value, and IRR?. No, the $2 million dollars is a sunk cost and has no bearing on the project's future cash flows. Now, I know this doesn't seem to make any sense but it's the way the financial world looks at things. What you spent in the past doesn't matter, even if it seems like it should. And never the financing costs. What do we mean by that? Financing costs would be the interest that's charged by the bank on a loan or perhaps the interest paid to bondholders. The project might be funded either by a loan or with bonds but we don't take the interest into account when doing our cash flow analysis. Here's another example. Your project requires a $1 million dollar investment. The company has cash on hand for $500,000 of that and takes out a three year loan to cover the other $500,000 at 10% interest. Do you include the finance charges (the interest) associated with the loan? No, you only worry about the cash flows associated with the project itself. How the company decides to finance the project is not included in the analysis, as that's a management decision and is independent of the project's value. Well, that's easy enough. That covers the cash flows we don't worry about. What about these? Would I call financial side effects. For instance, a project might have positive side effects otherwise known as synergies and financial parliaments. Here's an example to explain this idea. You propose a new software product that complements a physical product your company already sells today. Sales of the software product are likely to increase sales of the physical product. So, do you take the increase in physical product sales into account in your project evaluation? Well, it depends if the NPV is positive for your project independent of anything else, then likely no. No, you don't need to take the increased sales from the other product. Although I would definitely mention it in your presentation to the executive office. On the other hand, if the stand a loan project has a negative NPV but the combined value of the software product and the physical product provide a positive NPV, then definitely yes. What about things going in the other direction, creating a negative side effect, such as profit erosion or cannibalization of sales? Think about this case, you propose opening a new coffee shop one mile from your existing location. Sales at your existing location could decrease due to the new shop taking some customers as it's closer to where they live or work. This is an example of cannibalization. Do you take this erosion of sales and profits at the original coffee shop into account when evaluating the new location? Probably you need to show the overall impact to the business and the new shop definitely impacts sales at the existing shop. One way of dealing with this is to estimate what you believe sales will be at the new shop and what the loss in sales will be at the existing shop. And give your project what's known as a haircut, reducing sales in the new shop to account for the loss in sales at the existing location and then see if it still makes financial sense. Now, for the last one, what about certain environmental and social costs of your project? These are known as externalities, costs not borne by the project or the company but by someone else. Even if the project creates these extra costs, here's a very relevant example. Your project for a new production process requires a $1 million dollar pollution control device to comply with local emission regulations. Yet even though the company would be compliant, your new production operation still emits parts per million levels of contaminants that are really stinky, negatively impacting home values in the area. And more importantly, these contaminants create severe health effects for people with compromised lung capacity. Now the questions. One, do you take the $1 million dollars for the pollution control system into account? Definitely yes, you can't put the new production process into operation without it. So, that's a must, this is a true cost to the project. Do you account for the lower home values and degraded health of the people living in the surrounding area? Well and this is sort of sad but as of today you would not include those in your analysis, formal accounting practices do not require us to include externalities like these. However, that might be changing in the future. These days companies are becoming much more motivated to be good corporate citizens and might take this into account in the near future. More on that in the next course on finance for technical managers. Okay, here's an easy one. Do you take a pre-tax or after-tax cash flows? As we said, we only care about incremental cash flows and because you're proposing a project that will be highly profitable, those profits will get taxed. You need to pay those taxes and therefore they become a cash outflow resulting from the project. As a result we take taxes into account for our project evaluation. In general our cash flow analysis and subsequent NPV, IRR, and payback analyses are always done on an after-tax basis. Let's wrap up this lesson with a few main takeaways. We evaluate the financial value of a project using the net present value, the NPV, the internal rate of return, the IRR, and the payback period. These are determined from a project's future cash flows which are calculated from the after-tax cash flows coming from the project's operations. The cash flows due to inventory, something called networking capital and the cash flows due to the capital investment, the CAPEX. We only include the incremental cash flows from doing the project, never the some costs or the projects financing costs. We might include financial side effects whether they are positive or negative, but it depends on the situation. And finally, our cash flow analysis is always on an after-tax basis. That's an introduction to the first step in building our business case, getting the right cash flows to determine the project's NPV, IRR, and payback period. The one area we haven't really discussed yet is the idea of cash to build up or sell down inventory, technically known as part of networking capital. Most projects have more than just the CAPEX as a cash outflow. For instance, if you're selling a new product and you anticipate yearly growth in sales, then you need to add inventory each year to make sure you have something to sell and that takes cash. So, we need to account for it in our cash flow analysis. And that's the topic of our next lesson. A deep dive into networking capital. That's it for now though, I'm Michael Reedy and I'll see you next time.
