How should I calculate if a project is worth it?

How should I calculate if a project is worth it?

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How should I calculate if a project is worth it?

If you’re an entrepreneur without a strong financial background, one of the biggest business challenges you might face is the evaluation of a project’s financial implication. Often new projects are enthusiastically undertaken without proper consideration of the real profit the company stands to make.

A new project or contract always means more revenue, but often it does not end up being profitable in total.

If your business has been growing its revenue, but profit has been going sideways or down, your company is actually only spinning its wheels in terms of bottom line profit.

It might be time to implement a basic financial analysis before a project or contract is accepted.

Considering net present value

Before you roll out that new line of business or accept that project, take the time to consider its net present value. Sure, it generates income and keeps your team busy, but after prudently taking into account all costs and the effect of your cost of capital over time, is it still making you money?

 

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The process to undertake can be broken down as follows:

  • First, understand your company’s cost of capital
  • Plot your project’s cash flows over its life span
  • Calculate the project’s net present value using your cost of capital.

Cost of capital

Cost of capital means the cost of the equity (the owners’ own money) and debt (borrowed funds) of the company. It is calculated as the cost of equity times the weighting of equity in the capital structure, plus the cost of debt times the weight of debt in the capital structure.

Cost of Capital = (cost of debt x weight of debt) + (cost of equity x weight of equity)

A basic example to simplify this mouth-full:

Financial decision making

Peter’s company is half-funded by himself, and half by a loan. The weight of equity is therefore 50%, and so is the weight of debt.

The interest on the borrowed funds is 12% per annum. Because the interest is tax deductible, we use the after tax cost of interest. The cost of debt is therefore 12% x 0.72 = 8.64%.

Peter’s expected return on the money that he put in is 30% to compensate for the risk that he is taking in putting money into his business.

Let’s keep it as simple as this for our example. Applying our formula, Peter’s cost of capital can be calculated as:

Cost of Capital = (cost of debt x weight of debt) + (cost of equity x weight of equity)

= (8.64%x50%) + (30%x50%)

= 19.32%

Peter now knows that his company will need to generate returns of at least 19.32% in order for him to adequately cover his cost of capital.

Plotting your project’s cash flows

Peter’s financial decision is whether or not to purchase a new line of software with a five year licence for his design company. The new software will enable a new stream of income, as well as add to existing income streams and will cost him R200 000. He has plotted the project income and expenses over five years as follows:

Basic NPV model

On face value, it looks like the total net inflow for the project over five years coming in at a positive R328 400 is a definite must. But in order to properly analyse this, we need to compute the project’s net present value.

Net present value

The net present value of a project is the current value of all the project’s future cash flows, discounted at the company’s cost of capital.

In basic terms, the R21 200 profit of year one, discounted at the cost of capital rate of 19.32%, is worth only R17 767 at the beginning of that year. Likewise we discount each year’s profit back to its current (year zero) value to get the present value thereof.

The sum of these discounted amounts then make up the net present value:

Net Present Value

The project’s NPV comes out negative at -R14 407. As the NPV is smaller than zero, Peter should not accept the project as it will generate less present value profit than the cost of the funds employed in making that profit. Not the same answer as that of the first look at the project’s profit.

Likewise, doing a basic cost of capital calculation for your company and a NPV calculation for each new project, entrepreneurs can make better financial decisions that will drive bottom line profits instead of just spinning the wheels in one place.

Louw Barnardt
Louw Barnardt is the co-founder and MD of Outsourced CFO, a financial management boutique of Chartered Accountants that assists private company clients in gaining access to innovative funding solutions. Outsourced CFO carries fundraising mandates from leading venture capital companies, peer-to-peer lending platforms and financial institutions and have assisted numerous private companies to unlock finance and scale.