Financial Analysis Refresher Spring 2017 CE Conference Mark Myles - TURI
Financial Analysis Requirements Economic Evaluation of Potential TUR Techniques (310 CMR 50.46A) The TUR plan must include the discount rate, cost of capital, depreciation rate, or payback period, if any, used in each analysis The discount method, depreciation rate, and payback period must be consistent with the toxic user s current capital budgeting procedures The economic feasibility decision must be made at least consistent with the toxic user s current business decision making practices
Financial Analysis connects TUR Planning to Business Goals
Some Financial Analysis Terms Capital Expenditures (Capital Investment) Money spent to add or expand property, plant, equipment with the expectation that it will benefit the company over a long period of time Incremental Cash Flow Monetary difference between cash coming into company with and without a capital expenditure Economic Lifetime Period of time over which investment is expected to be productive Cash Flow Timeline Graphical depiction of cash flows attributable to an investment over a particular period
Depreciation Depreciation is a method of allocating the cost of a tangible asset (such as equipment and buildings) over its useful life. Depreciation accounts for how much the asset s value declines over time. Depreciation is accounted for as a cost, reducing income and therefore reducing tax liability. Thus, depreciation increases cash flow. Factory equipment is typically depreciated over 10 20 years.
Depreciation example New ultrasonic cleaning bath purchased for $12,000 with 5-year life, salvage value of $2,000. Tax rate 20%. Straight-line depreciation Year Depreciation amount Depreciated value 0 (purchase) $12,000 Tax savings @ 20% (inflow) 1 $2,000 $10,000 $400 2 $2,000 $8,000 $400 3 $2,000 $6,000 $400 4 $2,000 $4,000 $400 5 (salvage) $2,000 $2,000 $400
Cash Flow Timeline Inflows (savings): Increased production Avoided compliance costs Reduced waste & scrap Avoided treatment & disposal Reduced insurance Net increment Cash Flows Purchase, Installation Outflows (costs): Utilities Operation & Maintenance Raw materials
Incremental Cash Flow: Example Purchase of hard-piped solvent recovery system for a metal finishing plant. Costs: Equipment cost $ 8,000 Installation $ 1,000 $9,000 total capital expenditure Annual Operating Costs $ 2,000 Savings: The project will generate $6,000 in savings in each of the next three years Net Annual Incremental cash flow: $6,000 - $2,000 = $4,000 Should the project be implemented?
Cash Flow Economic Lifetime YEAR 0 1 2 3 Cash Outflows $9,000 Equipment $ 8,000 Installation $ 1,000 Net Cash Inflows Year 1 Year 2 Year 3 $ 4,000 $ 4,000 Total cash inflows = 3 x $4,000 = $12,000 Total return = $12,000 - $9,000 = $3,000 $ 4,000 The project returns +$3,000 over its lifetime
Measures of Profitability Simple Return Payback Return on Investment (ROI) Discounted Cash Flow Net Present Value (NPV) Internal Rate of Return (IRR)
Simple Payback (Payback Period, Breakeven Point) Measure: Time Required for cash flows to equal initial investment Formula: Initial Investment ($) Annual Savings ($/Year) Example: Initial Investment = $9,000 Annual Savings = $4,000 Payback? $9,000 $4,000 per year = 2.25 years YEAR 0 1 2 3 Cash Outflows $9000 Breakeven point Net Cash Inflows Year 1 Year 2 Year 3 $ 4000 $ 4000 $ 4000
Simple Payback Advantages Simple & Easy Disadvantages Does not consider the time value of money Does not measure the scale of gain of project When to use First-cut analysis or small / simple projects When not to use Long payback periods Variable cash flows Ranking multiple projects
Time Value of Money $1000 earned today is not the same as $1000 earned later! If you have $1000 today, you can invest it in a range of options with varying rates of return at varying levels of risk, such as: Financial Investments: stocks, bonds, mutual funds, etc. Insured savings deposits New plant and equipment New hired personnel Etc. Measure the value of money at different moments in time as determined by an opportunity discount rate Rate of Interest, or return, that a business or person can earn on the best alternative use of the money at the same level of risk. Also known as the Discount Rate
Time Value of Money Formulas Future Value FFFF = PPPP (11 + rr) TT Present Value PPPP = FFFF 11 + rr TT FV = Future Value PV = Present Value r = Rate at which funds could be invested (discount rate, or interest rate) T = Number of time periods (usually years) Present value is the critical element in financial analysis because we translate a project s future cash flows into today's dollars, permitting comparisons
Time Value of Money YEAR 0 1 2 3 Cash Outflows $9000 Equipment $ 8000 Installation $ 1000 Net Cash Inflows Year 1 Year 2 Year 3 $ 4000 $ 4000 $ 4000 These are the nondiscounted cash flows! Time Value of Money (TVM) A $ today is worth more than a $ in the future, because today s $ can be invested.
Discounted cash flows @ 14% YEAR 0 1 2 3 Cash Outflows $9000 Equipment $ 8000 Installation $ 1000 PV of Net Cash Inflows Year 1 $ 3509 Year 2 Year 3 $ 3078 $ 2700
Time Value of $1000 $1000 invested at 4% annual interest rate grows to $1480 after 10 years $1,600 $1,400 $1,200 $1,000 $800 $600 $400 $200 $- Future Value of $1000 at 4% Interest Rate 0 1 2 3 4 5 6 7 8 9 10 Year $1000 received in 10 years is worth only $676 in today s dollars, because if received today it could have been invested $1,200 $1,000 $800 $600 $400 $200 $- Present Value of $1000 at 4% Rate 0 1 2 3 4 5 6 7 8 9 10 Year
Terms Related to Time Value of Money Present Value The value of cash today for cash earned at some time in the future, calculated for a given discount rate Future Value The value of current cash calculated for some time in the future at a given discount rate Discount Rate Interest rate used to translate future cash flows into present value. Also called Cost of Capital and Rate of Return Annuity A periodic series of payments in the future due to an investment today
Time Value of Money Using Annuity Table PV of an Annuity (a series of equal payments from now until the future year) Payment amount x factor from intersection of year and discount rate PV of $1000 a year for 4 years at 8% = $1000 x 3.3121 = $3312
Net Present Value (NPV) Measure: Investment proposals are evaluated on the basis of present value created by the investment Method: Discount all cash flows by the appropriate discount factor and sum the present values NPV = Sum of PV (Cash Inflows) Sum of PV (Cash Outflows)
Discounted cash flows @ 14% YEAR 0 1 2 3 : Cash Outflows $9000 Equipment $ 8000 Installation $ 1000 PV of Net Cash Inflows Year 1 Year 2 Year 3 $ 3509 $ 3078 $ 2700 Year Cash Flow Discount Factor (@14%) Present Value 0 ($ 9,000) 1.000 ($9,000) 1 $ 4,000.8772 3,509 2 $ 4,000.7695 3,078 3 $ 4,000.6750 2,700 Net Present Value of Cash Flows (sum of Present Values) $287
NPV Interpretation GENERAL RULE: If NPV > 0: the project is financially acceptable If NPV < 0: the project does not generate financial return If NPV = 0: the project generates exactly the return that is required If NPV = 0: The savings generated by the project is sufficient to: 1. pay off the initial outlay of funds 2. pay off interest payments to creditors who lent money 3. provide the required return to shareholders If NPV > 0: The savings generated by the project is sufficient to accomplish 1, 2 & 3 plus: increased economic value of the business
Net Present Value Advantages Accurate considers Time Value of Money Measures risk-adjusted valued added to business Disadvantages More information and calculation intensive Requires estimation of cash flows over life of project and calculation of discount rate When to use Major project assessment and wherever conditions indicate that payback may be insufficient 23
Hypothetical example breakdown of actual use Labor Electricity Use Natural Gas Use Toxics Use Production Unit A 50% Production Unit B 35% 100% Production Unit C Production Unit D 15% 30% 40%
Conventional Accounting Cost allocation by proportion of labor hours Labor Electricity $ Natural Gas $ Toxics Use $ $ Production Unit A Production Unit B Production Unit C Production Unit D 50% 15% 50% 15% 50% 15% 50% 15% 50% 50% 50% 50% 15% 15% 15% 15%
Activity-Based Accounting Cost allocation based on activities that create them Labor $ Electricity $ Natural Gas $ Toxics Use $ $ Production Unit A 50% Production Unit B 35% 100% Production Unit C Production Unit D 15% 30% 40%