Sunday, February 14, 2021

Economic viability

You just got that dreaded call: your finance officer wants to talk to you about your project

The subject is "economic value add" aka EVA. 
You're thinking: Didn't that come and go as the flavor of the month a decade ago?
Perhaps, but it's still relevant for for-profit projects

So, here's what you need to know:
  • It costs money to raise the capital funds to pay for your project.
  • If not for your project, those funds might have been earning profits on something else.
  • Is, or was, your project a better opportunity?
  • Did your project improve the financial position of your company?

In simple terms, here's what your finance officer is talking about:

  • Perhaps the 'cost of capital' (CoC) for your project's funds was 6% of the money raised, for example (interest paid out on bonds sold for capital funds, or interest on loans, etc)

  • And -- as dubious as it may be -- the finance officer can establish a firm cause-and-effect between increased business profit -- say 10% return on the money borrowed (ROI) or $1M by example -- and the success in the market of your project. (*) 

  • The EVA is then just a calculation: 'Increased profit' x (ROI - CoC)
    In this case: $1M (10% - 6%) = $40K

Thanks for that! Your project actually improved cash flow and added to business financial success!

A better opportunity?

If there was another opportunity competing for the capital funds, then it would have to do better than return $40K on $1M raised the capital markets. The CoC might have been lower; or the ROI greater in order to best your project. 

And the risk attendant with making $1M in profit would also be evaluated with discounted cash flow analysis. Maybe your project is given a more favorable discount rate.

The finance officer makes all those assessments as input to the decision process to fund your project or not.


(*)  I say dubious because cause-and-effect is notoriously difficult to prove, to wit: there may have been other business changes during your project's time frame that also influenced profit. How do you disentangle that?

Buy them at any online book retailer!