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Financial Analysis Using Excel: The Essentials of Investment Decision Making. You can find the Excel examples discussed in these series at the following address. This video is the fourth in a four-part series that presents the essentials of financial analysis for investment decision making. In Episodes 2 and 3 we examined the Net Present Value, Maximum Capital at Risk, Benefit Cost Ratio, Internal Rate of Return and Pay Back. In this concluding episode we will use these financial indicators to make investment decisions.
Be aware that investment fall into two categories; mutually exclusive projects and independent projects. And signing among mutually exclusive alternatives investors must select the best project because they can only do one. On the other hand, investors can perform any number of independent projects as long as their funds last. With mutually exclusive investments where investors can only do one project, examples include; at what rate should an oil company produce from a particular oil well? How should a telecommunication firm provide a particular service package? What type and size of pump will best provide a specific service requirement?
The best decision tool is Net Present Value. Select the highest Net Present Value at a specified discount rate. With independent investment where an investors can perform any number of projects within the limit of his or her firms, examples include; how should manage when allocate money among various divisions of the large company? How should a firm prioritize investments for totally different endeavors? The best decision tool is Benefit Cost Ratio. You rank your projects according to the Benefit Cost Ratio at a specified discount rate. The highest ratio is the best project.
IRR pay back, Maximum Capital at Risk and various accounting rates of return represent useful information. But these tools do not provide consistent criteria for ranking independent projects or for selecting mutually exclusive alternatives. We earlier considered the discount rate which is the interest rate at which you evaluate projects. As an investor and analyst you must determine to receive for management the Minimum Acceptable Rate of Return. You will recall that the Minimum Rate of Return is also called the Hurdle Rate or Discount Rate. You have to use the same Discount Rate on all projects to make consistent decisions.
Another factor that influences decision making is Project Cost. You need valid capital and operating cost estimates. Accurate projections generally require a lot of work. And finally nothing impacts a project cash flow more than Revenue. You have to do your homework to make well considered estimates of future revenue. Consider Example 4 on Tab 4 which shows two mutually exclusive projects, the Discount Rate is 10% to shown here, in Cell B4. Alternative 1 generates a Net Present Value of 33. And Alternative 2 generates a Net Present Value of 39. So clearly Alternative 2 is better at the specified Discount Rate of 10%. Because the Net Present Value for 2 exceeds that of 1.
We can also see this in the Incremental Analysis. We are going to take the Alternative 2 and subtract Alternative 1. So we have done that for the cash flow. And what we end up is our Net Present Value of 6 for the difference between Alternative 2 and Alternative 1. So, again, clearly Alternative 2 is better.
Now consider Example 5. Here we have increased the Discount Rate to 15%. Alternative 1 generates the Net Present Value of 17 while Alternative 2 generates a Net Present Value of 11. So clearly here Alternative 1 is better. Now if we look at the increment of 2 minus 1, we are going to end up with a net present value that's negative. So this would indicate that again Alternative 1 is superior. Now turning our attention to Example 2. We will see four projects that are independent. In this case we have Benefit Cost Ratio of 1.8 with the first Project. Project 2: 1.18. Project 3: 1.14. Project 4: 0.88. So clearly Project 1 with the Benefit Cost Ratio of 1.8 is better.
Now let's examine Tab 6. We have another set of independent projects. This case all of these projects are summarized in a table at the bottom. We will see that we have a Benefit Cost Ratio of 1.51, 1.73, 1.14, 1.36. So the highest Benefit Cost Ratio indicates best independent project, Project 2. If we increase the Discount Rate to 25% and reexamine our table, we will see that the highest Benefit Cost Ratio is now present with Project 1. This drives home the importance of being clear from the hurdle rate.
In summary if you calculate Net Present Value, Benefit Cost Ratio, Internal Rate of Return, Maximum Capital at Risk and Pay Back, you have all the financial measures required both, to compare your project to other projects and to sell your projects to your sponsors or to your stake holders. The Net Present Value provides the means to select the best mutually exclusive alternatives or Benefit Cost Ratio presents a gauge to rank your project against other independent projects. The Internal Rate of Return, Maximum Capital Risk and Pay Back provide other valuable information to help you and your stake holders measure your project's performance.
You can find the Excel Financial Analysis Examples discussed in this series on our website at the following address .In addition; you will find a sample Excel: Discount and Cash Flow Model at this address. The simple Discount and Cash Flow spreadsheet contains all of the elements you need to perform a typical after-tax analysis, assuming you use the appropriate tax rate, depreciation schedule and discount rate. I will discuss these subjects in future articles. For more information on this topic visit us at toweringskills.com .If you have specific question relating to financial analysis or project management you can post your queries on our forum .Also at towering skills dot com.
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