Sell Your Project! (page 3) (Link to page 1)


GOOD ENOUGH ISN'T ALWAYS GOOD ENOUGH

If the project makes money, we've won our case, right? Wrong. Making money is easy.  Making enough money is the trick.  How much is enough? There are several answers to that question, and you'll need to adapt to your specific situation.

Many companies have a "minimum attractive rate of return" (MARR) or "hurdle rate" which all projects must meet or exceed.  This is an interest rate or return on investment that they will require before a project is considered viable. Where does your company get the funds that it will invest in your project?  If it borrows them from a bank, it will pay the bank interest.  If your project doesn't make enough money to pay back the interest, and make more money besides, it will not fly.  In this case, your hurdle rate will be at least equal to the cost of borrowing money.

Alternately, your company may have cash reserves, being handled by some investment firm.  If these cash reserves are currently bringing in a 12% annual return, your project had better return more than 12%, or they will not be enthusiastic about allocating cash to it.  However, in rare instances, it is possible that strategic or intangible factors will outweigh this hurdle rate, such as expanding into new markets or seeking new long-term strategic capabilities.  But don't count on that.

Frequently, the actual hurdle rate is dynamically changing above these minimum values, based on the competing projects from other engineers with ideas almost as good as your own.  Even if the cost of money is only 12%, and your project will return 20%, there is a finite amount of cash to go around.  If other projects on the list of candidates all return 30%, odds are yours will not get the green light.

So, we've got to do more than just show that our project is profitable.  We need to show how profitable it is.  To do this, we need a slight twist on our analysis.  In the formulas and lookup tables discussed above, we had to use an interest rate.  What rate did we use?  Actually, we didn't say.  A common technique is to use the prevailing interest rate that you expect to govern most financial transactions during the time period of your project.  This could be a composite of the current inflation rate and the going rate on loans your company takes out.  But there are other options.

To show that we can beat a hurdle rate, we use the corporate hurdle rate as our interest rate in our formulas or tables.  If our project present value comes out positive, it shows that we have beaten the hurdle rate.  So far so good; we've shown that we can beat the benchmark, but we still haven't show precisely how good the project is.

A slightly more involved approach is to find the break even interest rate.  That is, the interest rate that would make our CBA show a present value of exactly zero, so that all incomes and expenses, adjusted for time, cancel out.  The interest rate that makes this happen is the overall rate of return of the project.  Unfortunately, this requires an iterative solution (or a computer approach), but it tells us much more and gives us better ammunition to defend our project.

As a simple example, consider a project that costs us $1000 to start up, and pays us $500 per year for five years.  Is this a good project?

Assume we have a corporate hurdle rate of 10%.  Using our AV to PV formula, we can convert our AV into a PV by calculating

PV = $500[((1 + 0.10)5 - 1) / (0.10(1 + 0.10)5)] = $500(3.791) = $1895.50

Now, the total present value = positive flow - negative flow = $1895.50 - $1000 = $895.50

Since the total present value is positive ($895.50), we know that we have beaten the 10% hurdle rate.  But to find the actual project rate of return, we must find the interest rate that makes this equation balance, or sum to zero.  Clearly, the conversion factor must be equal to 2.00 for the Present Value of the payback to equal the initial costs of $1000.  We can see, either from our tables or by trying a few values in the formula, that the conversion factor has dropped from 3.791 to 2.035 when interest rate climbs to 40%, so we can say that our project's rate of return is slightly better than 40%.


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