How to make a business case
What are relevant things to include in a business case, and how do you make sure that this Business Case is based on facts and not made to make it just look nice? There is a complete finance book behind this, but the idea is to spare you the read, and instead give you an example of a simple business case, that can be used for project evaluation.
The first step is to get an overview of what your project will cost when, and how much it will bring in, according to your Marketing Department. These are things that are not that easy to get. It’s called Cash Flows.
Let’s say your project needs a “Machine” that costs 200.000. (Let’s not worry about depreciation, that the machine will depreciate in value over time and may not be as valuable in the end. I added a sell value of 25.000 just to highlight this though).
With your new machine, you will be able to produce items to sell, that will bring in 180.000 per year.
Let’s say fixed costs are 50.000 per year, and variable costs are 40% of sales.
Note: All these estimates should come from proper forecasts of sales and costs. The Cash Flows can only be costs that occurs if the project is undertaken. Cost of management, buildings that needs to be paid anyway and other ongoing costs (sunk costs) should not be included. Opportunity cost may be included, as in “what could we use this for if the project was not undertaken”.
To understand how much revenue the project will earn, we need to take Sales-fixed costs-variable costs. We now have EBIT – Earnings before interest and tax. The iT (Interest and Tax) can have a big impact on the project value, however I will not go there right now.
PV is Present Value. Also called “Free Cash Flow”. This is the amount of money that can be taken out of the project without disrupt its cash flows. Present Value. It means the value of the money NOW. Today. If you have 10.000 coming in next year, it’s worth less if you wanted to use it today. This is because of interest rates. 10.000 tomorrow is worth 9090 today if the interest rate is 10%. 10000/(1+i)=9090, 1000/1.10=9090. If you, on the other hand, had 10.000 now and wanted to lend it out to someone until next year, the calculation would be opposite. 10000*1.10=11000. So in order to find the present value of something (what it’s worth now), we need to discount it until today. Discounting it is to divide it with the 1+interest rate. But what is the interest rate? It’s the cost that the company has of getting money. In this example, the simple rate is 10% (1.1). We call it WACC – Weighted Average Cost of Capital. A lot of other things are included in the WACC such as how much dept or equity (stocks) the company capital structure consists of. WACC also takes risk in to consideration. Your finance department will provide you with the proper number. If the project has the same risk as the company, the WACC can be used. Otherwise a project WACC needs to be calculated. How to determine that? If you are introducing a new product line, your project may have a higher risk than the company. If it’s just an extension of something well tested before, it may not. (I’m trying to keep it simple here so I’m not going in to the details – let’s assume the risk is the same).
So for every period (every year) we need to discount the EBIT with 10% WACC. To make it a bit more complicated, we also need to add a compounding effect. As you always earn interest on interest lending your money out. Long story short, every period needs to be “raised to powers”. This usually scares most people away from finance, as it looks “mathy” and cumbersome. First year: 58000/1.1^1 = 52727. Second year 58000/1.1^2 = 47934. This is the compounding effect in action.
NPV – is the Net Present Value. It represents the value of the future cash flows NOW. Today. This is the base of all financial evaluations of money. What is it worth today? We can see the value 35389. That is the sum of all the Present value streams-the initial cost of 200.000 for machinery.
The NPV can also be seen as the value in how much the shareholders wealth is increased. Why is this important? All companies (on the stock market at least) seek to increase the value of their shares, and to grow. With a modern business case calculation that takes the time effect of money in to consideration, we can see with how much the shareholders wealth would increase if the project is undertaken. If comparing multiple projects, we can see which one gives the best NPV (provided that the cash flows are correct). Clearly, if a negative NPV is undertaken, the shareholders wealth would decrease, they would lose money.
So in the end, the project, if undertaken, will bring in 35389. That’s great. There is more than enough money in the capital market to fund all projects that has a positive NPV. But there are multiple other considerations to make that comes after. How to fund it? Equity (stock, shares) or Debt (bank loan, bonds)? A combination? This may be another post at another time.
I hope this added some value to your financial understanding. Please comment and let me know.