This process refers to measuring and evaluating the profitability of the project, and it involves estimating viability indicators like the present value (PV), the net present value (NPV), internal rate of return (IRR), payback period (PBP), the breakeven point, and collective financial ratios. The viability test of a project shows the profitability based on specific assumptions. The (PV) results from the discounted future cash flows, whilst (NPV) shows the net (PV) after covering the initial investment (a proxy of investment cash flows). The (IRR) is the investment’s overall return that makes (NPV) equal to zero; in other words, it is the discount rate that makes the (PV) equal to the initial investment. The (IRR) varies depending on the type of cash flows used to figure out the net present values and can be (IRR- Investment) (i.e., the present value of future free cash flows from the investment- operating cash flows minus cash flows from investment or initial investment), or IRR-equity- free cash flow from investment minus cash flows from loans. The IRR-Investment shows the net cash flows that can be used against cash flow from finance (Loans and equity), while IRR-Equity represents the net cash flows against equity (net worth of the company). The breakeven point indicates the level of revenues (as values or quantity) that the company starts at, making a profit, and is calculated by dividing the fixed costs (e.g., marketing and sales, administration, and general expenses a year) by the contribution margin or amount. The investment decision, whether to approve or reject an investment opportunity, typically lies in aligning its viability results with the industry indicators. As a rule of thumb, healthy (PV), (NPV), (IRR), and (PBP) results are positive if they are positive and above the average industry benchmarks. The significance of profitability indicators shows the profitability measurement and enables the decision-making about the investment opportunity.
Step-By-Step Process
- Clarify the study’s details on the income statement, balance sheet, and cash flow statements.
- Decide on the weighted average cost of capital (WACC) or the discount rate.
- Prepare the table of cash flow statements for (5-10 years), including the cash flows from operation, investment, free cash flow investment, cash flow from loans, equity, and free cash flow equity.
- Calculate the terminal value of the project at the end of ten years as net operating cash flows (free cash flows from investment and equity). The terminal value is cash flow at the end of the year (10) multiplied by (1+ growth rate) divided by capital discount (discount rate minus growth rate).
- Obtain industry benchmarks and performance indicators, especially regarding the viability indicators like (PV), (NPV), (IRR), (PBP), and (ROI), to validate your investment viability.
- Draft the viability results for discussion with your team and experts.
- Evaluate and test the outcomes of the viability results.
Example
Here are the viability results of a pharmaceutical manufacturing facility:
| Details | PV ($ Mil.) | NPV ($ Mil.) | PBP (Year) | IRR-Investment (%) | IRR- Equity (%) | ROI- Accounting (%) | Break-even Point ($) |
| Results | 243 | 215 | 7.11 | 32 | 41 | 37 | 26,712,442 |
Useful Tips
- Set reasonable assumptions about the discount rate, growth rate, and cash flow statements.
- Validate your viability results with the industry benchmarks for decision-making.
Things To Avoid
- Avoid guess works and assumptions without evidence.
- Avoid your judgement without sharing the discussion with your team and experts.
Final Note
This article is sourced from my new book- Your Guide For Preparing An Industrial Feasibility Study. For more information about the book: https://growenterprise.co.uk/book-your-guide-for-preparing-an-industrial-feasibility-study/To register in our newsletter: http://eepurl.com/ggcC29Or email us at: maldawood@growenterprise.co.ukThe author: Munther Al Dawood- Industrial Enterprise Expertwww.growenterprise.co.uk
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