How do you tell if your project is viable or not?
There are many systematic ways of ascertaining the viability of your project over a period of time. We will look at an overview of the different financial analysis tools at your disposal.
At the simplest level of analysis, you will want to make sure that the total costs of any project you undertake are less than the total benefits resulting from the project. You could simply add up the costs, and then add up your expected revenue increases and cost savings over the project’s life, and compare the two.
However, if you simply did that, you would be ignoring the fact that many of the costs will be incurred at the beginning of the project, while many of the revenues or cost savings will occur later, over a period of months or years since benefits to investments can sometimes come with a lag.
There are a number of more formal ways to evaluate the costs or benefits that a purchase or project will bring to your business. The most commonly used are the following: Payback period analysis, Accounting rate of return, Net present value, and Internal rate of return.
Each of these methods has its advantages and drawbacks, so generally more than one is used for any given project. And no financial formula, or combination of formulas, should be used to the exclusion of common sense! For example, a project may “fail” your tests under some or all of these methods, but you might decide to go forward with it anyway because of its value as part of your long-range business plan.
The payback method is the simplest way of looking at one or more major project ideas. It tells you how long it will take to earn back the money you will spend on the project. There are a couple of drawbacks to using the payback period method. For one thing, it ignores any benefits that occur after the payback period, so a project that returns K1 million after a six-year payback period is ranked lower than a project that returns zero after a five-year payback. But probably the major criticism with the payback is that these methods ignore the time value of money.
A fairly simple way of gauging your return on an investment in a project or purchase is the accounting rate of return (ARR) usually expressed in percentage terms.
Unlike the Payback method which only considers the period it takes to recoup the original investment, under the ARR, returns for the project’s entire useful life are considered. However, just like the Payback method, the ARR ignores the time value of money.
Instead, the net present value (NPV) method of evaluating a major project allows you to consider the time value of money. Essentially, it helps you find the present value in “today’s kwacha value” of the future net cash flow of a project. Then, you can compare that future amount with the amount of money needed to implement the project now. The drawback with the NPV is in choosing the appropriate discounting rate (cost of borrowing), which may not be easy to decide sometimes, especially when there are major differences between Reserve Bank rates and the rates in the financial markets.
Lastly is the internal rate of return (IRR). This method of analysing a project allows you to consider the time value of money. Essentially, it allows you to find the interest rate that is equivalent to the returns you expect from your project. Once you know the rate, you can compare it to the rates you could earn by investing your money in other projects or investments (known in economics as opportunity cost).
Blessed weekend to you and yours as you reflect on whether your project is really viable.
