The second factor reflects a corporation’s alternative options for both internal and external investment. The discount rate must be greater than the return from standard financial investments or else the company will invest its money there. (Alternatively, the firm could pay a dividend to shareholders with the cash and the shareholders themselves could invest in these standard investments.)
The third factor, closely related to the second, accounts for the differences in the predictability of the cash flows produced by investments. The cash flow from a new pump is likely to be much more predictable than that from a new software system that has never been installed in the plant before. In accordance with financial analysis theory and practice, when the actual value of the cash flow is not fixed but can only be estimated, a risk premium that recognizes the uncertainty or riskiness of the estimated cash flow should be added to the discount factor. More complete explanations of these factors are available in financial analysis texts such as Brealey and Myers . Again the standards used by your company should be the ultimate guide.
The financial analysts will then compare the profitability of various investment proposals from all parts of the corporation and rank them. One key ranking used is the profitability index:
Where NPV(ATCF) is the net present value of after-tax cash flow generated by the investment and NPV(IC) is the net present value of invested capital. Reference 1 provides details on the equations underlying this expression.
It is common to graph the sequence of investments and resulting cash flows. The elapsed time to reach a positive cash flow, i.e., the time at which the discounted cumulative cash flow crosses into the positive region, is important. This is sometimes called the discounted payback period.
Companies obviously favor investments with a higher risk-adjusted profitability index and a shorter discounted payback period than others.
If your project gets funded, the analysis is not over, however. A key to successful long-term project financial management is to regularly, rigorously and objectively post-audit major investments to see whether they achieved their predicted return on investment. The first step in this process is to capture a set of base operating data prior to the installation of the system. Comparing these data with operating results after installation of the new system or technology allows calculation of the improvement. (Often this requires correction to standard operating conditions or adjustments due to changes in raw materials or operating conditions.) This analysis can identify areas in which there were unanticipated problems or benefits and lead to better evaluation of future investments.
Make the right case
We all want our preferred investments to be approved. The prospects for success will improve if we understand the criteria by which corporate financial management allocates available funds and if we build the credibility of the value of an automation project by realistically estimating its benefits and costs.
1. Brealey, R. A. and S. C. Myers, “Principles of Corporate Finance,” 7th Ed., McGraw-Hill Irwin, Columbus, Ohio (2003).
2. Auget, T., E. Bartels and F. Budde, “Multiple Choices for Chemical Industry,” <itals>McKinsey Quarterly<end itals>, No. 3, p.126ff (2003).
Douglas C. White is vice president, APC Services, for the Process Systems and Solutions Div. of Emerson Process Management, Houston. E-mail him at Doug.White@EmersonProcess.com.