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Sunday, October 17, 2010

Business Case - Financial Metrics

When reviewing a business case scenario that requires an investment of capital and resources financial metrics that summarize the expectation are utilized as part of a decision making process.  The following are metrics utilized in an evaluation:
  • Net Cash Flow
  • Net Present Value (NPV) / Discounted Cash Flow (DCF)
  • Internal Rate of Return
  • Payback Period
  • Return on Investment (ROI)
Net cash flow is the heart of the business case and is a measure of cash inflow versus outflow.

      Net Cash Flow = Cash Inflows - Cash Outflows

A business case should always include net cash flow because it provides a basis for the following:
  • Planning/budgeting
  • DCF/NPV, IRR, and payback
  • Starting point for Management to optimize results 
Discounted Cash Flow (DCF) / Net Present Value (NPV) is a cash flow summary that has been adjusted to reflect the time value of money.    DCF makes use of the present value concept that money you have today is more than an identical amount you receive in the future because future money would have an interest return.                                                                         

Internal Rate of Return (IRR) is a cash flow summary that has been adjusted to reflect the time value of money.  The IRR for an investment is the discount rate for which the total present value of future cash flows equals the cost of the investment.  It is the interest rate that produces a 0 NPV.

When reviewing IRR the following are points to remember:
  • All things equal the investment with the highest IRR is better
  • IRR says nothing about the size of the return.  A small investment may lead to a large return.  A smaller IRR on another project may be preferred if it brings in a larger net cash flow.
Payback period is the length of time required to recover the cost of an investment, typically measured in years.  All things equal, the better investment is the one with the shorter payback period.

Return on Investment (ROI) decision makers evaluate investments comparing the magnitude and timing of expected gains to the magnitude and timing of investment costs.  A good ROI means the investment returns compare favorable to investment costs.

A couple points to remember when reviewing ROI:
  • ROI by itself says nothing about the likelihood that expected returns and costs will appear as predicted.
  • ROI does not identify the risk of the investment/project.
  • ROI simply shows the returns if the actions/investments bring the results planned.
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