Difficult moments in the analysis of investment projects - Effective CFO

Complex moments of the analysis of investment projects

The first problem is connected with the isolation of incremental operational flows. Often the project is implemented as an addition to the business already being implemented. For example, additional equipment is purchased to increase output, a quality control system is put in place, investments are made in the creation of a brand, a brand. Effects in the form of revenue growth can be obtained not only on a narrow segment of the output to which the investments were directed. The analyst will have to take into account the so-called indirect effects. On the other hand, increasing output often does not require a proportional increase in all current costs. Part of the costs are permanent and do not change with the change in output, therefore, in the investment project analyst, the investment proposals evaluation manager is often based on managerial rather than accounting data. Fundamentally important is the allocation of current costs, which are directly related to the project and change quantitatively. In the analytics, the terms incremental operating costs and incremental cash flows & quot ;. Advanced computer programs allow you to allocate fixed and variable costs, simulate options for using alternative processes, consider the formation of incremental cash flow throughout the value chain. But this, in fact, a new look at investment modeling.

Another difficult moment associated with the forecast of operating cash flows is the reflection of price changes (in general, inflation). The forecast can be constructed in base prices, then there is a flow of real money. Alternative construction of nominal flows is associated with the introduction of a forecast of prices for products and for cost items. This version of the forecast is more complicated, so it is used less often. Companies with well-functioning investment analytics at the first stage of analysis (express analysis) work with real flows, and at the second stage they carry out more thorough analysis of the market and build forecasts of nominal earnings and outflows. Small companies are often limited to express analysis, arguing that the change in prices in the numerator of the formula NIRU corresponds to the inflation rate that is taken into account in the denominator, i.e. discount rate. As a result, real cash flows are compared with the real discount rate. Such a calculation will not lead to errors, unless changes in prices for key factors in the implementation of an investment project are comparable to inflation expectations. Otherwise, gross miscalculations are possible.

At the stage of express assessment of the project, interest on borrowed capital is not included in the analysis. The situation of financing completely own capital is simulated. Features of working on borrowed capital, sophisticated schemes for attracting and repaying loans are modeled at the second (in-depth) stage of analysis, when the effects of individual participants are evaluated.

The second problem is the evaluation of investment costs. For example, a company has in its assets unused production facilities that can be used to implement a project for the production of new products. There will be placed the equipment and inventory. The question arises whether to take into account in the analyst the cost (for example, balance) of the used building. Often on the part of company managers, a positive response sounds, because in fact, the project is more assets, than attracted funds. In value analytics, the answer is more cautious. If the existing building and communications are not involved in the company, and there are no alternative possibilities for their use, their contribution to the project is considered as a competitive advantage and is not fixed in the form of investment costs. Another thing, if the premises and other assets were involved, brought cash flows to the company, and after making a positive decision on the project, they will be reoriented. Alternatively, there is the possibility of alternative use of buildings and premises, for example through leasing or selling. In this case, as an alternative cost, the lost profit from assets excluded from use and reoriented to the project should be considered as an additional line of investment costs.

Another aspect related to the assessment of investment costs is the costs incurred earlier. For example, a few years before the review of the project, the company could already carry out marketing research, prepare technical documentation, bring communications to the existing territory. The question arises whether these costs incurred should be taken into account as part of the investment costs of the project. Analysts say no. These are already made and irretrievable costs (sunk costs), which should not be taken into account when assessing the effectiveness of an investment project. The fact that these costs allow the company to save on marketing and other expenses is a competitive advantage that contributes to the investment attractiveness of the project.

Often a forgotten element of investment costs is investments in current assets (inventories, accounts receivable). For some areas of activity (trade, processing of materials), these investments can be significant. Analysts recommend calculating investments in current assets and take them into account at the investment stage, and in the liquidation of the project include in the receipt (return) of funds. Often two methods of estimating investments in working capital are used: a method of a share in proceeds; method of specifying the turnover ratios according to information from already implemented projects or by analogical companies.

When purchasing equipment, complex equipment, it is necessary to take into account the period of installation, commissioning, development of the created capacities. At the stage of project liquidation, additional investment outflows, as well as investment proceeds related to the sale of assets, are possible.

The third problem is justification for the discount rate. Since investment outflows and operating cash have a different level of risk, different rates should apply to them. For investment outflows, a risk-free rate or a rate on the company's borrowed capital, which reflects the minimum investment risk, is often fixed. The situation is more complicated with the rate for operating outflows. Traditionally, when evaluating NPV, the equality of discount rates by years is laid down.

When answering a question about choosing a bet, two directions of calculation are observed. The first direction is based on setting a conditional rate (for example, at the level of borrowing with a small premium or even from a risk-free rate) with a reflection of the risk in cash flows. The most often used for risk accounting are methods of valuation of sensitivity to rate changes, and scenario estimates. The second direction is to adjust the discount rate to the risk of cash flows estimated by the project. It is actively used by financial and investment consultants, large investment companies, private equity funds, actively supported in academic literature. The first direction in the simplified variant of variation of parameters is often realized by small and medium-sized companies. The largest market companies (BP, RDShell) are actively using simulation modeling, which allows them to concentrate less on justifying rates.

The method in the context of cost analysis, which is more often used in practice than NPV (as empirical studies show), is the definition of yield, or internal rate of return (internal rate of return, IRR). The essence of the method consists in calculating the annualized rate of return that the investment project provides, and comparing it with the range of rates of alternative investment in the market. The idea of ​​comparing the earned and required profitability was discussed in Ch. 3 for economic profit models. Recall that the activity is effective if the spread of efficiency is positive. the difference between the received and the required profitability taking into account the risk. A similar requirement is also laid on the projected yield on the investment project. The biggest difficulty here is the correct calculation of the average yield for a certain period (for example, a year), when the monetary benefits come over a number of periods and are not equal to each other. The calculation by the formula of the average arithmetic profitability for years does not fit. Analysts find the answer in the formula of the internal rate of return, in which the current investments are equated to the above assessment of benefits. Note that the adjustment is possible not only at the time t = 0. Such a relationship can be considered for any future moment in time. For example, you can calculate the value of IRR by balancing future investment cost estimates (at project completion) with future estimates of current receipts.

This analytical method has two significant advantages. First, the evaluation of the project in terms of annual returns, and not in absolute values ​​of the increment in value. Absolute values ​​of cost estimates are difficult to perceive by non-professionals, they are quite problematic to monitor during the implementation of the project. Yield per cent per annum as a characteristic of the project is more understandable for comparisons and evaluation of benefits. Secondly, a fixed discount rate (as provided in the NPV method) is not required to make a decision on the project. It is enough to understand the range of alternative rates on the market. If the project's profitability is known to be higher than the various market rates (project estimates are often observed at 80, 120, 350% per annum), then the project is considered effective.

Many companies in determining the provisions for the adoption of the investment program and investment budget fix the value of the barrier rate of investment. So, for the profile projects of the company "Lukoil" (oil production, oil refining), the rate was fixed at 15% per annum (referring to projects estimated for ruble cash flows). Development company "Sistema-Hals" does not consider projects with yields below 21%.

The IRR metric reflects the maximum permissible level of costs for the capital involved in the project. For example, if the project could be completely financed by a bank loan (a completely unrealistic assumption), the value of IRR would show the upper limit of the acceptable level of the interest rate. A higher rate would lead to "eating" project of company value. Often, examples of project financing are provided using exclusively borrowed funds, but it should be borne in mind that the assets of the project and the company that carries it out are the guarantee of these funds. In this regard, with full loan financing of the project, it is incorrect to ignore the risk of owners of the company's own capital and their required level of profitability.

The complexity of the method consists in the correct calculation of the profitability of the investment project, according to which the cash flows are not equal in terms of years, have a different level of risk, are "smeared out" in time. The traditional calculation of the internal rate is based on finding a discount rate that equates the present cost estimate with the current estimate of future revenues. In other words, the root of the equation of the degree n (where n - the lifetime of the project) is sought:

Graphically finding IRR means finding a point on the NPV graph of the project when you change the discount rate, in which NPV becomes zero.

The meaning of this calculation of profitability is well demonstrated by the situation with the finding of a rate, which makes the investor's position neutral to two possible investment decisions. The first solution is to save the investment amount, refuse to invest in the project and reinvest it every year at a certain percentage. The second solution is to receive in return the investment amount of periodic cash flows that are nominally equal to the flows of the investment project and can also be reinvested at a certain rate. Finding IRR - is the finding of the interest rate that equalizes these two investor decisions.

The described method of determining the profitability of the project has critical remarks as a formal settlement plan (for example, the situation may be absent in the equation, the presence of several roots), and economic, semantic. The first (main) remark concerns the low realism of the assumption of the possibility of reinvestment of project money amounts at a settlement rate. Only a very small number of projects can fall under this assumption ("walking excavator", when the investment project is annually duplicated). The second observation is the different risk of investment outflows and operating cash flows under the project.

It is more correct to calculate the rate of return of the project using the formula of the modified internal rate of return (MIRR), when two bids are introduced reflecting the real market environment of the project: financial, outflows and often taken at the level of risk-free or lending rates (average cost of borrowed capital); the refinancing rate available to the company.

The following formula is used to calculate the desired value for the MIRR rate:

where/-y is the future cash flow estimate taking into account the introduced refinancing rate, IMS = I - 1.

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