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financial modeling

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Table of Contents:



Business Valuation Techniques:


see our discussion on:  business valuation




How to Evaluate Projects


1. Quantitative Techniques


The core of capital budgeting is learning how to make good financial decisions when presented with choices for how to spend your money.  In the end, there are many financial modeling techniques such as "internal rate of return"(IRR), and "payback period method", but when comparing two projects on a quantitative analysis...always use net present value to choose the better project


Using the skills of financial modeling, the analyst will look at the sum of cash inflows (revenues) and outflows (costs) in the full life cycle of the product.   These cash flows normally start out negative with development costs, then ramp up costs, marketing and support costs and finally product costs.   Soon thereafter, you hope that the product will be accepted by customers, and you will then begin the cash inflows through revenues.


With the sum of 4 negative cash outflows, and 1 positive cash inflow...all occuring at different times...how do you determine if the project is a good one (and worth spending money on)?


The most commonly used technique for capital budgeting projects such as these is NET Present Value (NPV), which figures out the present day value in todays dollars of all of the expected future cash flows.


NPV:  While the techniques of net present value may be very valuable in evaluating a project based solely on the financial numers, a manager should be more alert to the other many factors that influece the qualitative evaluation of project finance.  Why use NPV analysis during product development? Because it helps to provide objective evaluations of projects and also brings a level of systematic control and accountability to corporations making project finance decisions.  Problems with NPV are numerous, and are fully outlined in our discussion on capital budgeting



NPV analysis (net present value)


Net present value analysis is the classic financial modeling method taught at most MBA business schools.  Its a technique that allows managers to compare future cash flows in terms of todays dollars.  Its allows managers to put a dollar value on expected future cash flows, and to compare one project vs another.  When comparing projects on NPV analysis, the one with the higher NPV always wins.


The problem with this method is that it seems very precise.  The output is a very exact number, and managers can be fooled into thinking that precise is the same thing as accurate.  It is not.  The NPV analysis can be very inaccurate, depending upon which assumptions you base your calculations.  If you change one assumption (future growth, market size, competition, etc), it can dramatically change your NPV output. 


So, if you are ever presented with an NPV analysis, please take a moment to critically challenge the underlying assumptions.


Another problem with NPV, is that it depends upon which discount rate the analyst has chosen.   But, this discount rate can be very difficult to estimate properly.  The trouble is that different projects might be more attractive than others depending upon which discount rate is chosen for the analysis.  Be very careful when presented with an NPV analysis that compares two projects, and digg deep into how the discount rate was calculated.  One project might be better at lower interest rates, but another is better at higher rates.


For more discussion about the benefits/ troubles of NPV analysis, please visit our discussion on net present value



IRR analysis:


Internal Rate of Return analysis tries to overcome some of NPV's weaknesses.  Specifically, it seeks to help the novice analyst to avoid needing to make assumptions about the discount rate (which is needed for NPV, but not for IRR calculations).  This is the second technique often used in financial modeling.


While IRR is conceptually easy to understand, it is not really a good tool to use for capital budgeting decisions.   You should never compare IRRs directly from one project to another...you will make mistakes.  This is because the better project (financially speaking) is not the one with the highest internal rate of return, but the one with the highest overall NPV.   The trouble with IRR is that it does not take into consideration the overall size of the project.   For example, a tiny project might give you a 45% rate of return, but it might not be possible to scale up that project to be meaningful in terms of overall return.  On the other hand, there may be million dollar investment that you can make and get the overall best return. 


But, if you are determined to use IRR for capital budgeting, then here is what you do.....compare the incremental cash flows of the two projects, and calculate the IRR and NPV of that incremental cash flow.  Take the project with the larger initial cash outflow, and subtract the smaller project. If both projects have the same initial outflow of money, then look to the first cash flow and subtract so that the result of that subtraction is a negative number. Then do the IRR of the incremental cash flow.   That IRR is the break even point. That is the point above which you choose one project, and below which you choose the other. This works because IRR figures out the discount rate at which NPV is =0. But, in this case, we are comparing two projects against each other, so it figures out the break even point.



Using "Options" Analysis to pick the right project:


Managers that use textbook NPV analysis are ignoring the real world facts that there is the option to make new decisions at a later date.  For this reason, project finance is a bit more complicated than simple NPV analysis would make you believe.   


please see our discussion on real options for more on this topic.




2.  Qualatative Analysis (looking outside of NPV) 


In addition to the measureable factors such as cash flows, there are other important factors that may be more difficult to measure, but that still have a major effect on the decision about whether to develop a project or not.    There are dynamic and competitive environment factors that need to be considered, as some projects (most projects) are strategic (and not just financial) in their nature. 


But just looking at the quantitative measures such as NPV will often lead managers to miss the best investing opportunities.  In addition to business-school MBA-like calculations about net present value of cash flows, a good manager should also consider whether or not the investment in this one project could act as a platform for future innovation and growth (in essense, an option for future growth).  Also, it needs to be considered how the project fits into the competitive environment (see discussion about flanking strategy), and with the strategic position of the company.  Looking only at NPV will often lead managers to make bad decisions. 


Qualitative factors to consider:

  1. interaction of project and Firm - will knowledge obtained from this project spillover, and help the firm as a whole?  Does the firm have spare capacity to take on this project?
  2. interaction of project and Market - how will competitors react to the development of this project?
  3. interaction of project and macroeconomic environment - how will exchage rates change?  How will that effect profitability globally?  for outsourcing?


Why consider these factors?


  • Ceteris paribus:  the assumption that "all other things being equal":   This is a fundamental assumption underlying all NPV analysis, and it ignores the three qualitative factors listed above.   It assumes that decisions made by the company do not affect competitors, and that competitors reactions do not affect the profitablity of the project.  It assumes that the macro economic environment will still be the same in the future, and it assumes that changes in macroeconomic factors do not change the decision criteria for the project.  This is clearly wrong, but is essential component of most financial models (such as net present value NPV analysis).
  • For more discussion about how to use Qualitative factors when looking at projects, please visit our page on financial modeling



Sensitivity Analysis:


Please see our discussion on sensitivity analysis for financial modeling



Optimum Product Mix:


This type of calculation is done to model the costs/ benefits of different production mixes on overall profitability.  It is often associated with cost accounting and with effective operations managment.


For more, please see our discusson on product mix decisions




External Links:


Selected areas of financial modeling application



Links to KookyPlan pages 



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