Many decisions are motivated by cost, and the effectiveness of decisions is often defined by their impact on profitability. Sabisu now provides easy to use functions that can help with finance related choices, such as calculating project/investment feasibility, and determining which new asset option represents the best value for money.
Net Present Value
Net Present Value (NPV) is a method to evaluate the current worth of an investment based on a series of annual cash flows. It is commonly used to evaluate the financial feasibility of projects.
NPV incorporates the time value of money (TVM) into its analysis. This principle describes the greater benefit of receiving money now rather than later, and explains why interest is paid or earned. As an example, if you were to deposit £100 into a savings account for one year it is reasonable to expect that you would increase in value due to interest. At an interest rate of 5% the initial deposit will be worth £105 in one years time (£100 x 1.05). Put simply, £100 received now is worth £105 in one year.
Conversely, if someone promises you £100 in one years time the value of the money right now is not £100, as if you had it right now you could invest it and earn interest (at 5% if we deposit it in our savings account). The value of the money today is £100 / 1.05, which is £95.24.
NPV uses this TVM principle to determine the present value of a set of annual cost/benefit streams. If the resulting NPV is positive, then it means that the investment will add value to the business. If it’s negative then it would subtract value and the project should be rejected.
Investment Opportunity – An Example
Barry is very carefully considering a proposal from a small external company who wish to partner with his firm to produce a new product line. To do this Barry’s firm would invest £10,000 to set-up the necessary machinery, the external company would then manage production and promise £3,000 each year for 4 years.
To Barry this seems like a feasible project, with a £2000 profit after 4 years giving a 20% return on investment. However, he takes it to the finance director for verification.
The finance director immediately spots Barry’s mistake, he hasn’t considered the time value of money. The £3000 that the firm will receive at the end of the year isn’t worth £3000 today, and the £3000 at the end of year 4 is worth even less! This all needs to be offset against the initial investment.
The finance director calculates the Net Present Value of the project using a discount rate of 10% (this is usual, as the discount rate not only accounts for interest that could be gained from a bank, but also other factors such as changes in inflation). The NPV of the project is found to be -£490.40, which means that under the suggested agreement their firm would lose money.
There are, however, many ways in which this deal can be changed slightly to give a positive NPV, making it a good investment. For example, the agreement could be extended by a year, the external company could pay £4000 in year one (or any other year), or Barry could simply ask for a higher amount each year. NPV can be used to formulate these plans, and order them in terms of profitability.
Equivalent Annual Cost
Equivalent annual cost (EAC) is the effective cost, per year, of an asset. It can be used to compare the cost effectiveness of various assets over different periods.
If a new asset is needed there are often different options available. Some will have a smaller initial cost, but may cost more to maintain, or have a shorter lifespan compared to higher priced equivalent assets. EAC can be used to evaluate the cost effectiveness of these different configurations so that the best decisions can be made
Choosing a New Compressor – An Example
A new compressor is needed for a chemical production plant. Two options have been presented:
Compressor A | Compressor B | |
Initial Cost | £60,000 | £140,000 |
Lifespan | 4 years | 9 years |
Annual Maintenance Cost | £12,000 | £7,000 |
This is clearly not a straight forward comparison. Compressor A is less than half the price of Compressor B, but has a shorter lifespan and higher maintenance costs. EAC provides a method to compare the equivalent costs of the two assets, a discount rate of 5% is used to represent the cost of capital:
Compressor A EAC = £28,921
Compressor B EAC = £26,697
The EAC tells us that the annual cost of Compressor B is lower than Compressor A, meaning that even though the initial cost is higher, Compressor B is the sensible option.
Sabisu Finance
Here we have introduced some of the new financial functionality within Sabisu, using examples to show where they can be used. Sabisu makes these techniques easy to apply, requiring only the most basic information. This ensures efficient and effective decision support for a wide range of project and budgeting scenarios.
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