Investment Modelling

Companies invest capital in a range of projects, which hopefully will result in positive cash flows and thereby add value to the company to repay all the providers of capital. This includes both shareholders and debt providers as discussed previously. It follows from the cost of capital logic that a company should invest in projects that provide a return above the cost of capital and reject projects that fail this test. Such decisions are linked to strategy, since a company may be replacing old equipment, investing in new areas or replying to competition.

Financial modelling assists this process since it is possible to create a cash flow model to encompass all the rules and cash flows. Modelling helps to identify the variables, discover new variables and understand better how the variables behave. The process could be as shown below:

Project

1.     Identification of alternatives

2.     Set rules for project evaluation

3.     Identify costs, cash flows and sunk costs

4.     Model investment

5.     Review and revise model

6.     Risk and sensitivity assessment

7.     Model risk, sensitivity, simulation

8.     Review and accept/reject findings

9.     Review non-financial factors

10.  Implement

11.  Monitor and feedback

While there is a whole range of qualitative factors in capital budgeting decisions, the Excel model concentrates on producing quantitative answers to management tests about the investment. Management must decide on an investment in return for the future cash flows and therefore the model needs to present the best estimate of the future. Investments need to possess a good chance of success and fit with management strategy for the business as a whole.

There are a number of methods that can be used to evaluate the investment and the model seeks to pick out the attractiveness of the project. The methods are:

·     Payback period and discounted payback – how long it takes to get 1 million back.

·     Accounting return – the average accounting profit to the average investment (return on invested capital).

·     Net present value – discounted cash flow (DCF).

·     Internal rate of return (IRR).·     Benefit to cost ratio – present value of benefits divided by the initial investment.

·     Management tests – cash flow, and so on.

The model generates a manufacturing account, income statement, balance sheet and cash flow (see figure below). As you may recall, the cash flows that must be included are:

·     Incremental – the cash flows must be extra and dependent on the investment rather than existing cash flows (that is, cash flows that would be there without the project).

·     When the company is paying tax, then the after-tax cash flows should be evaluated against and after-tax discount rate.

Excluded costs include the following:

·     Sunk costs that the company has already incurred. For example, an existing building may already have been lying idle and this could be viewed as an opportunity cost of zero since it is already empty and not being used.

·     Non-cash costs such as depreciation of fixed assets and amortisation of goodwill. These are accounting entries and not physical cash flows.

·     Financing costs are usually included in the discount rate. This is to avoid double counting of the funding effect.

·     Costs which are not certain. The model errs on the side of caution and away from ungrounded optimism.