In this article I want to talk about project profitability and financial cash flow. This is not the monthly cash flow number you have to report to management, but the overall project financial cash flow and how it fits in with the capital budget and project profitability. The capital budget is a corporate plan outlining the planned expenditures for fixed assets. Capital budgeting is the process used by a plant to analyze projects and decide whether or not they should be in the capital budget. In the capital budgeting process, the cost of a project must be developed. The project team develops estimates of the expected cash flows (benefits) from the project including an analysis of the level of risk of the cash flow. This cash flow is the money the asset will generate for the company or the benefits in the rate of return calculations. These cash flows are then discounted at the corporate cost of capital and compared to the capital cost. In general, if the present value of the cash flow streams is greater than the cost of the project, the project should be accepted.
There are several methods used to determine the attractiveness of projects or are they viable. These include:
Payout (Payback) the expected number of years required to recover the original investment. This is a measure of the length of time the funds will be tied up in a project. The shorter the payback period, the less risky a project will be since the capital investment is recovered more quickly.
ROI The Return On Investment is the after tax income divided by the fixed capital. It gives a rough indication of the percent return on the funds invested.
DCF The Discounted Cash Flow rate of return computes the discount rate at which the project after tax cash flow stream must be discounted to equal the capital investment. This method yields a rate of return that can be compared to the corporation’s cost of capital. If, for example, the cost of capital is 10%, then projects with DCF rates of return greater than 10% would be accepted.
The premise behind projects is to find one that has an acceptable rate of return and can make a profit for the company. Once found, the company goes through the project life cycle to make sure it is the right project and the cost of the project is still in line with the rate of return. If the math is good the company goes out into the market and borrows money to fund the project. In other words, the company borrows money to make money.
The overall profitability of the asset is shown by how positive the cash flow becomes during it’s operational life. As the project progresses you have to monitor cost and schedule. When you are over budget or behind schedule it has an affect on the overall rate of return and profitability. Three items affect the profitability. They are:
- Project over budget
- Delay in project schedule
- Project under performance.
We will look at how each of these affect the profitability.
The dashed line in Figure 1 shows how the cash flow behaves for a project. The funds for the pre-project and design phases are usually out of an expense budget while we check to see if the project is still viable. If viable the company will borrow money to fund the project and go into the procure and construct phase. Just like loans you take out, the company borrows money for the project and they have to make loan payments (principal + interest) while constructing the asset. As you go through the project the company is paying out the loan and if everything goes as planned, the project is built on schedule and on budget.
The asset is started up, put into operation as planned and starts to produce a positive cash flow. The initial money the project makes goes to pay off the loan. Eventually the loan is paid off and the asset starts to make a profit for the company. At the end of it’s life, the asset is decommissioned and demolished. The asset has met it’s projected profitability.
Of course this is ideal which most of us may never see. Figure 2 shows what happens when you are on schedule but over budget or you overspend.
As you start overspending on your project the company may have to borrow more money to keep the project going. The solid line is the overspending line. Eventually the project is completed and it starts to make money. Because of the overspend, the operational phase has a lower starting point to recover from. This affects the rate at which the asset delivers a profit as the interest payments have to come from the operational profits depressing the overall profitability. Eventually the loan is paid off and the project starts to make a profit. At the end of it’s life it is decommissioned and demolished. Since the life of the project is considered fixed it will not recover the profit it was originally expected to produce. This difference between what it should have made and what it did make is the Lifetime Asset Loss. Of course, under spending will enhance the asset cash flow.
A similar situation arises when you are behind schedule. This is shown in Figure 3. In this case you are spending money for a longer period of time before the asset can start delivering a positive cash flow and you can start paying back the loan. Even though no overspend there will be larger interest payments which will affect the operational profit. It is difficult to recover from this situation. Even if the project has a high rate for return, you will never recover what was originally conceived. You could also have a shortened operational life as the decommissioning point may depend on external factors. As well, with delayed schedule, you keep the project team on the project longer which incurs additional costs. All this means you will end up with the Lifetime Asset Loss. Of course if you finish sooner this will enhance the assets cash flow.
The last item to affect profitability is the effect from under performance of the asset. The project must deliver an asset capable of performing as specified. The asset in Figure 4 fails to deliver.
This is one of the reasons plants only want to buy tried and true equipment, they want to play it safe. The asset has to perform in order to be profitable. If using inferior equipment it may not perform and in the end the project will be a failure.
For overspending and schedule delay your company has procedures in place to help you stay on track for profitability. These are areas you have control over. For the assets themselves you have less control so you should use specifications, standards, and a preferred vendor / equipment list to handle this issue. This is what your projects are all about and why it is important to get them up and running as soon as possible. Your company is looking for the positive cash flow from the asset.