Lesson 1: Forecasting 

Rating Your Returns
Imagine you’re about to invest in a new piece of capital, like a machine that paints penguins yellow. Before you spend $1 million on this venture, you want to ensure it’s going to be profitable. This involves calculating the rate of return on the machine. The rate of return is the ratio of revenues to costs associated with the purchase. If it’s positive, you’re earning more than you’re spending, which is favorable for the company. Conversely, a negative rate of return indicates a loss, something companies strive to avoid.

The rate of return is typically measured over years, although it can be calculated for any time frame—months, weeks, days, or even hours—depending on the investment’s lifespan and how much effort you want to put in.

I prefer simplicity in capital budgeting, so the first thing I do is calculate the rate of return on a potential investment. This allows me to quickly eliminate investments that won’t be profitable or that are significantly less profitable than other options.

For instance, if an investment only yields a 1% annual return, but a local credit union offers a 3% return on a savings account, it’s better to choose the savings account. By determining the potential of each project early on, you can avoid unnecessary work. Sounds good, right?

To calculate the rate of return, you’ll need the following data:

• Pricing and financing costs

• Operating costs

• Output volume

• Lifespan

• Revenues

These five pieces of information are all you need for the calculations in this chapter. For this section, we’ll focus on the rate of return, but rest assured, you won’t need anything more for the remainder of the chapter.

Looking at costs
When purchasing new capital, it’s often costly to buy and maintain. You need to consider three separate costs:

• The purchase cost

• The interest rate on the loan used to buy the machine

• The cost of maintaining the machine

The purchase cost usually includes a tax expense, but when doing calculations, I prefer to keep things straightforward.

Calculating revenue
After figuring out your costs, the next step is to calculate your revenue. You wouldn’t invest all that money unless you expected to generate some revenue, right? So, let’s look at revenue. For our purposes, focus on two main types of revenue:

• The sale of the products made by the machine

• The salvage value

In reality, you’d also consider tax savings through depreciation and possibly more than one machine to create a finished product. The revenue generated by a single machine represents only a portion of the total sales, based on the machine’s contribution to the final product. While additional capital might mean more calculations, they’re not truly new, so I won’t cover them again.

Calculating the accounting rate of return
The simplest rate of return to calculate is the accounting rate of return (ARR). This basic calculation helps determine how much value an investment generates for the corporation and its shareholders. You only need two pieces of information: the earnings before interest and taxes (EBIT) generated by the project and the investment cost. Here’s the formula:

ARR = EBIT attributed to the project ÷ Net investment

The ARR is calculated by dividing the EBIT generated by the project by the net investment. This tells you the proportion of net earnings before taxes generated for the investment cost, typically calculated annually. However, since this equation doesn’t account for multiple periods, you’ll need to recalculate it for each period (usually a year). For example, in year 1, you might calculate a –3% rate of return, which sounds bad, but sales usually start slow for new product lines. By year 3, you might expect a 2% rate of return.

To determine the EBIT attributed to a specific project, you essentially create an income statement for the new project. Calculate the sales generated by the new line or product, then subtract the operating costs. Simple, right? Now, let’s add some complexity to calculate this for a single machine rather than an entire project.

When your capital investment is just one step in the production process, determining the added value by that step takes more effort. Break down the entire production process into individual steps, with the total production process representing 100% of the final product.

There are a few ways to determine what percentage of the production process a single step constitutes. One method is to use a proportion of the total production cost. This method is easy but not the best. A better approach is transfer pricing, which estimates the market value of each step by researching how much it would cost to hire another company to perform that step. This method offers two benefits:

• It helps with capital budgeting by determining the added value for that step and the amount of EBIT attributed to it, ensuring a positive return on investment.

• It establishes the fair market value of performing that step to assess financial efficiency. If another company can perform the step more efficiently or at a lower cost, consider outsourcing it.

If you know the lifespan of the project or machine, you can forecast the rate of return for each year. Success in this forecast depends on how closely your predictions align with the actual rates of return. The total rate of return on the investment is the total EBIT generated by the investment divided by the investment cost. The revenues used to calculate EBIT include all revenues generated over the investment’s lifespan, plus the final revenue from its salvage or scrap value.

Making the most of the internal rate of return through modification
The accounting rate of return (ARR) is helpful, but it’s quite basic and limited in providing useful information for managing assets, investments, and projects. For more detailed analysis, use the modified internal rate of return (MIRR). The internal rate of return (IRR) is a useful equation but has some flaws, so the MIRR is often preferred.

The IRR attempts to calculate the rate at which the net present value of future cash flows is zero. Essentially, it estimates the rate at which a project’s value is zero at the start, as no production has occurred yet. However, the IRR has a couple of issues:

• It assumes all project cash flows are reinvested at the IRR rate, which isn’t always realistic.

• It struggles to compare projects with different durations and cash flows.

Despite these drawbacks, the IRR can be used to evaluate a single project or cash flow. However, the MIRR is generally more accurate in assessing project costs and profitability, making it the preferred choice.

Here’s the formula for MIRR:

MIRR = n √ (FV (Positive Cash Flows, Reinvestment) / PV (Cost, Rate)) - 1

Where:

• n = Number of periods

• FV = Future value

• PV = Present value

• Positive Cash Flows = Revenues or value contributions from the project

• Reinvestment = The rate generated from reinvesting future cash flows

• Cost = Investment cost

• Rate = Financing rate

• 1 = A constant

Usually, the reinvestment rate for MIRR is set at the corporation’s cost of capital. However, this depends on the corporation’s financial management efficiency, so it’s often treated as a variable based on financial performance evaluations.

Here’s a quick example of how to calculate the MIRR for a project:

Suppose a project lasts two years, with an initial investment of $2,000 and a 10% cost of capital. It returns $2,000 in year 1 and $3,000 in year 2. Reinvesting at a 10% rate of return, you calculate the future value of the positive cash flows as:

$2,000(1.10) + $3,000 = $5,200 at the end of the project’s two-year lifespan.

Next, divide the future value of the cash flows by the present value of the initial cost ($2,000) to find the geometric return for two periods:

$5,200 / 2,000 = 2.6 - 1 = 1.6 = 160%

Note that this calculation doesn’t include financing costs, as $2,000 is a manageable amount for most corporations. Had we used the IRR instead of the MIRR, the rate of return would be higher but less accurate.

Netting Present Values
One of the core calculations used in capital budgeting is net present value (NPV). The NPV is calculated using this equation:

NPV = Σ (Ct / (1 + r)^t) - C0

This equation sums up the present values of all future cash inflows and subtracts the sum of the present values of all future cash outflows. Essentially, it adds and subtracts the present value of all future cash flows, both positive and negative. If the equation seems complex, that’s due to the nature of equations. The big “Σ” symbol, known as sigma, means to sum things up—in this case, the present value of future cash flows.

In capital investments, cash flows typically consist of revenues and costs. These differ slightly because they’re operating revenues and costs, not financing or investing cash flows. Positive cash flows come from the sale of goods and services and the return generated through reinvestment. If the investment is part of a larger process, attribute only the revenues representing the proportion of the total value that the investment contributed to the final product. Costs include financing, maintenance, operations, and interest paid on financing. All cash flows are assumed to be discounted at the expected inflation rate.

Calculating NPV over time
What makes NPV special in capital budgeting isn’t just projecting the total value of a potential investment; it’s the ability to calculate NPV over time. Over a project’s lifespan, the NPV decreases as the project generates revenues and has fewer unrealized cash flows. Performing these calculations allows you to:

• Determine the investment’s value over its life, useful for evaluating corporate value and future operating potential.

• Estimate the market value of an investment at any given time, which can be useful as collateral or to determine its liquidation value. Although it’s a grim scenario, it’s essential to be prepared.

• Gather vital information about reinvesting net cash flows up to that point.

Managing the project’s value
When you calculate a project’s NPV at time t (any year during the project), you can add the actual returns generated up to that point and manage the project’s value more effectively. Forecasts are always estimates, and their accuracy varies, so when a forecast period ends or is nearing completion, check how close you were to the forecast. This allows the corporation to adjust its financial outlook accordingly. The net cash flows generated so far are known as earned value. Earned value is calculated as:

EV = Σ PV(Completed)

This equation simply adds up all the present values (PV) you’ve completed so far. The large “Σ” symbol (capital sigma) means to sum things up. “Start” indicates the beginning of the project, while “current” represents the current period. Add together the cash flows from the start to “now” (whenever “now” is), and that’s your earned value.

If your earned value exceeds your planned value at a given point, you’re generating higher returns than expected. If it’s lower, you’re generating fewer returns. In either case, it’s wise to understand the reasons behind the difference. Even if returns are higher than planned, knowing why can help you replicate that success in the future.

Tracking the NPV of a project allows you to manage it more effectively, allocate finances and resources more efficiently, and plan better for the future. These tasks are fundamental to project management, which I’ll briefly discuss at the end of this chapter.

Paying It Back
This section, in contrast to the previous one, is short and straightforward. It covers the payback period, which is the time it takes to recoup the initial investment in a piece of capital. In other words, it’s the number of years needed for a corporation to break even on its new capital investment. The payback period is crucial for projecting cash flows, interest payments, and other value management techniques, as well as for assessing the investment’s impact on the corporation’s overall asset management and profitability. It’s calculated like this:

Payback period = Initial investment / Net annual cash flows

Start with your initial investment, then divide it by your average net cash flows. For example, if you spend $10,000 on a piece of capital that generates an average of $1,000 in EBIT per year and has a 20-year lifespan, the payback period is:

$10,000 / $1,000 = 10 years.

It will take ten years to recoup the capital investment. The net cash flows generated during the remaining ten years are pure profit. Nice work!

This calculation assumes the initial investment is made all at once. However, it doesn’t have to be. For large investments, you can use the future value of all amortization payments as your initial investment. In other words, if you need to finance a large investment and repay it over many years, just sum up all the negative cash flows. This process is called amortization. Calculating the payback period for an amortized investment only works with fixed interest rates, where the nominal repayment amount doesn’t change over time. With variable-rate loans, the calculation is more complex and beyond the scope of this book.

Allocating Capital
Now it’s time to see how all the information in the previous sections comes together to help you make informed decisions about capital allocations. You’ve done a lot of calculations to determine the value and profitability of a capital investment at any given time, but what about comparing different potential investments? Remember, every investment has an opportunity cost—the loss of the next best option—so corporations must ensure they choose the best option, which may include no capital investment at all.

Calculating the equivalent annual cost
A good starting point is calculating the equivalent annual cost (EAC) for each potential investment. This is done as follows:

EAC = NPV / [(1 - (1 + Discount rate)^(-n)) / Discount rate]

This equation allows you to compare the annual costs of potential investments with different durations and cash flows in an apples-to-apples manner.

However, the real test of an investment’s success depends on the corporation’s ability to derive value from the project. Just because the capacity to create something exists doesn’t mean the demand or success will follow. To assess this, you need to calculate capital efficiency:

CE = Output / Expenditures

Once you understand the actual output generated by a project, you can glean additional insights. First, you can determine the cash flows at a given efficiency rate and how much that efficiency needs to increase to boost the project’s NPV. The deviation between current performance value and planned NPV corresponds to the efficiency improvement needed from the investment.

Next, use the estimate at completion (EAC) to determine which of several potential investments will generate the greatest returns for the corporation. Thanks to the analysis's equivalency, the option with the highest EAC is the best choice. Unless, of course, they all have low or negative EACs. If they’re all negative, you’ll lose money on all of them, and it’s better not to invest. If they’re all so low that a financial investment or bank account offers better returns, go with that option.

The next logical discussion topic is liquid asset management. This involves frequent analysis of whether to allocate resources to liquid assets with low returns but low risk or long-term assets with higher returns but higher risk. As noted, if your long-term potential assets have low returns, why take on the additional risk? Opt for the liquid investments.

Considering liquid assets
Allocating resources to capital investments involves more than just long-term assets. Although long-term assets typically get the most attention due to their high cost and risk, liquid assets also need evaluation for performance and returns. Deciding whether to invest in a long-term asset or keep funds in a liquid account largely depends on the corporation’s liquidity risk and estimated future cash flows.

Corporations aim to generate the highest returns possible from every penny. However, given the timing of costs and expenditures, they must maintain a certain level of short-term liquid assets, known as economic capital. This includes money kept in banks, cash, or any other immediately liquidatable form to cover daily cash requirements.

Money in economic capital isn’t invested, so carefully assessing liquidity risk, cash needs, and future cash flows is crucial for efficient asset utilization. It might be tempting to invest more than is operationally wise to maximize returns, but that’s a temptation to resist.

The other type of liquid asset to consider is inventory. Inventory includes all assets intended for sale, such as finished products, work-in-process, and raw materials. These highly liquid assets not only prevent investment but also incur storage costs. That’s why many corporations focus on and innovate in inventory management, aiming for JIT inventory management (just-in-time).

To illustrate, here’s a description of the production process progression. Each phase has its costs and valuations; JIT aims to reduce costs at each step, ensuring that inventory arrives just as it’s needed—ideally in small, frequent deliveries.

• Finished products: These are ready for sale. Storing them until they’re sold incurs costs. Direct sales tend to be cheaper because storage and distribution costs are lower without retailers, especially for made-to-order products.

• Work-in-process: These products are partially completed. Reducing in-process time can cut costs and increase returns.

• Raw materials: These are unprocessed materials. Most inventory management focuses here, ensuring materials arrive just in time.

The primary cost of inventory is storage. Like any other capital investment, the increased expenditures for storage space and maintenance, known as inventory costs, can reduce the returns from selling inventory as capital. JIT aims to manage the supply chain so that inventory in its various forms arrives exactly when needed, minimizing costs. By applying NPV to inventory management, you can see that JIT can significantly increase capital returns. By shortening the time capital is tied up in inventory, the NPV of inventory increases almost immediately. The benefits are twofold:

• Corporations can generate returns on money that would otherwise be tied up in inventory.

• Corporations can reduce the opportunity costs associated with short-term liquid assets.

Managing Projects
Project management is a complex field that involves various management specializations. For this book, focus on evaluating and controlling project finances using earned value management (EVM). EVM allows you to accurately calculate the value contributed to or derived from an investment project. The goal is to ensure everything remains on schedule, under budget, and, most importantly, efficiently profitable.

Value schedule metrics
As discussed in Chapter 9, time is money. Any deviation in the project schedule—whether falling behind or generating value ahead of schedule—indicates a problem. Falling behind is particularly bad, but even generating value ahead of schedule can mean the corporation’s assets weren’t managed as efficiently as possible.

Schedule variation
The difference between earned value (EV) at time t and planned value (PV) for time t is called schedule variation (SV), calculated as:

SV = EV - PV

This equation shows that schedule variation is the difference between earned value and planned value. If earned value at a given time matches the planned value, SV is 0. Being above 0 is good but still requires an explanation to improve future projections or replicate successes. If SV is less than 0, it indicates trouble.

Two possible reasons for a negative SV are:

• The project may not be generating as much value as expected. This can be identified by auditing cash flows to determine why they deviate from their planned values and whether this trend will continue.

• Earned value may be taking longer to materialize. A longer operating cycle than expected could cause this delay. Although less harmful than underperforming, it’s still a concern.

Schedule performance
Another way to assess the variance between EV and PV is through a ratio called schedule performance (SP), calculated as:

SP = EV / PV

This equation shows that SP equals earned value divided by planned value. SP can be measured using time increments (SPt) or dollar value increments (SP$). An SP of 1 means the investment is generating value as planned. Less than 1 indicates the project is behind schedule or underperforming, while more than 1 suggests the project is ahead of schedule or overperforming. In both cases, the corporation may not be using its assets as effectively as it could be.

Performance metrics are usually based on time milestones. Since the project’s value and time performance will be 1 by the end, measurements are taken at intervals set before the investment. Common intervals include 10% repayment period, 50% repayment period, or 50% asset lifespan, with multiple measurements over time.

Budget metrics
This section ties everything back to budgeting. When allocating resources to an investment, the corporation must create a budget for the investment. Since substantial funds and resources are spent to generate a return on investment, sticking to the budget is a significant measure of the investment’s success. The investment’s performance will also be reflected in updated MIRR calculations over time, but additional EVM calculations focusing on budgetary issues can help identify why MIRR deviations occur.

Cost variance
A corporation’s concern with how much value it can derive from an investment at a given cost is understandable—no one wants to keep throwing money into a “money pit.” Achieving the anticipated 100% value from the investment on budget is ideal. Any variation is calculated like this:

CV = EV - AC

Where cost variance (CV) is earned value (EV) minus actual cost (AC). Spending more to generate value at given milestones is a bad sign. You may need to reassess whether pursuing the investment’s value is worth the additional costs. If the actual cost is lower for a given point in earned value, you should start planning how to use the surplus budget.

Cost performance
Like time schedule metrics, another way to look at cost is through a ratio called cost performance (CP), calculated as:

CP = EV / AC

This ratio measures earned value at a given point against actual cost (AC) at that point.

Estimate at completion
The total cost of the capital investment at its completion is calculated using the estimate at completion (EAC) equation:

EAC = BAC / CP

Where:

• BAC = Budget at completion

• CP = Cost performance

The planned budget for the entire project is divided by the cost performance of the investment to give a dollar value representing the actual cost compared to the planned cost. Here’s a quick example:

EAC = $10,000 / 1.2 = $12,000; you are $2,000 over budget.

The $2,000 is called the estimate to complete (ETC), calculated as:

ETC = EAC - AC

You subtract the actual costs from the estimated cost at completion to see how much it will cost to finish the project.

Whether to continue an over-budget project depends on whether the ETC is lower than the potential NPV of future cash flows, calculated as:

Efficacy of investment = NPV - ETC

If the ETC exceeds the NPV of future cash flows, continuing the project is a waste of money.

To-complete performance
Whether a corporation can improve the financial efficiency of an investment to make it worth pursuing is calculated using the to-complete performance (TCP) ratio:

TCP = (BAC - EV) / (BAC - AC)

Subtract the earned value (EV) from the budget at completion (BAC) and divide the result by the BAC minus the actual cost (AC). This ratio tells the corporation by what percentage it needs to increase its performance efficiency. For example, if the TCP is 1.10, the corporation needs to improve efficiency by 10% to get the project back on track to be completed on budget.