In the second in his series on Investment Analysis, Tim Podesta continues with the subject based on a series of three seminars for the UK Chapter PMI during 2018 and 2019. The J curve shows cash flow and is the basis of economic evaluation.  There are two parts to the cash flow: the outflow investment – the expense and then the inflow of revenue – the return .

All economic analysis is based the cash flow. Where I worked we had two main economic indicators that were calculated for each project and used as part of the business case.

1. NPV (Net Present Value)- discounted cash flow at a prescribed cost of capital – discount rate.
2. IRR (Rate of Return) – effective interest rate of the cash flows

Let’s take look at the assumptions behind the value calculation.  These are key to understanding the business case, which is only as good as the assumptions that underly it.

What is your favourite sport or TV competition show – is it football, cricket, rugby or strictly come dancing?  What do you look out for?  The SCORE!  Remember that point as I explain Investment Analysis. For you the important thing is the SCORE.

There are 5 key factors to consider – these are labelled on the diagram and make up the SCORE S for Sanction of the Project

C for Capital Cost

O for Operating Start-up

R for Revenue Stream

E for Endurance of the Asset

SCORE is a useful acronym because it implies a reference point and a benchmark of the key assumptions which need to be delivered by the Project Plan.

To help with my explanation I’ve made some simple assumptions to create an NPV – the numbers are in green in the figure. Sanction – 10% cost of capital

Capital cost – 100 – 50 per year

Operating Start up – 2 years

Revenue – 20 per year for 10 years = 200 total

Endurance – 10 years

We also have NPV defined as the sum of the discounted cash flow IRR as the interest rate of the net cash flow.

Translating the SCORE data from the J Curve slide into a simple spreadsheet gives us the following: The Sanction point;  The Capital cost ; The 2 Year Operating Start up;  The Revenue and The 10 Year Endurance

I now add two lines for the cash flow in red and use these to calculate the net cash flow. This generates the curve on our graph and the cumulative gives us the payback period which is another economic metric that is often used. Let’s now add the discount factor at the bottom of the table based on 10% along with the resulting discounted cash flow.

We’ll use the net cash flow to calculate the discounted cash flow  and finally, use the sum of the discounted cash flow to calculate the total NPV. NPV = £15  – the current value of the cash flow at the cost of capital

IRR = 13% – the effective interest rate of the cash flow.

What do you think?  This is certainly a reasonable investment as long as we are confident in the assumptions. Now with this as the basis of assumptions that affect the elements of SCORE and therefore the cash flow – any variance in these will affect the value of the project.

In the next two blogs I will share stories that illustrate the elements for SCORE that underpin the Investment Analysis.

Read the first in Tim’s series on Investment Analysis

Read blog number three in Tim’s series

Read the final post in Tim’s series