Knowing whether an investment into your business is going to work is often a gamble based on assumptions and is not a guarantee for success. However, despite the uncertainty, there are various methods that you can employ to get a better idea of what you are getting into and whether those initial assumptions on their own are profitable to your business.
In order to analyse the viability of the project, we can employ capital budgeting techniques such as:
Payback Period - How long it will take to recover the initial cost of the investment
Net Present Value - Determines what future cash flows from the project are worth now
Sensitivty Analysis - Aids in showing what will happen to the bottom line of a project if it fails to perform as expected.
Since the relevant calculations for the Payback Period rely on actual cash inflow and outflow, accounting cash flows such as depreciation are not considered initially, but are added back into the mix after tax is accounted for. The calculation for the Payback Period is:
Payback Period = Initial Investment / Annual Payback (afer tax)
Based on that calculation, we can determine the amount of years before the investing company starts making money. Whether this is acceptable or not, is usually detemined by company choice.
For an investment project to be considerd successful, the Net Present Value calculation must be equal to or greater than 0, meaning that costs of the project do not exceed future cash inflows. The Net Present Value calculation is a bit more difficult in that it requires the use of a discount rate (directly associated witht the level of risk the project assumes) and the useful life of the asset acquired. It also only considers cash flows that exclude non-cash items such as depreciation.
The required calculation to compute the Net Present Value is:
Net Present Value = [Cash Flow/(1+i)t - initial investment
If a company was to complete a Sensitivty Analysis, that is, to dertermine how sensitive the figures are to change, the discount rate would rise and the effects of that risk or change in circumstances could be seen.
Where it was to be determined how many units of an item needed to be sold before a project ‘broke-even’ then this would call for a Breakeven Analysis, the calculation of which is:
Q = F –D / P – V (cash) OR Q = F / P – V (accounting)
Where:
Q = Total Units
F = Total Fixed Costs
D = Depreciation
P = Price Per Unit
V = Variable Costs
This is of course, a general overview of come capital budgeting techniques and is in no way exhaustive. As a business owner, you may not need to complete these types of calculations often, if at all. However, in order to get a better understanding of your business and how your investment choices may affect your bottom line, it is certainly recommended to have a general understanding.
If you need some assistance or advice in your direction, why not book a discovery call with our friendly team below.