Business Tools Blog

A question from Chris Murphy:

Could you please explain the financial metrics used to determine whether a large capital project should be approved?

On July 14th, I answered a similar question related to SBC and Capital Intensity Ratios for smaller capital projects.  I hope Chris’s follow up question means that he has big deals pending in his sales funnel.

There are 4 additional metrics that we use for larger capital projects.

Cash Invested
Cash Returned
ROI
IRR

Calculating these are easy:

Step 1 - Set up a table

• Column B is monthly Project Cash Flow (this example shows the first 12 months cash flow negative)
• Column C is Project Cash Flow By Year
• Column D is Cash Invested through cash flow positive.  The project starts generating cash in Month 13, therefore cash invested sums months 1-12.
• Column E is Cash Returned after cash flow positive.  The project starts generating cash in Month 13, therefore cash returned sums months 13-36.

Step 2 - Calculate ROI

• ROI (Return on Investment) tells the company what return they get back for the money
  spent (investment).
  • The formula is Cash Returned/Cash Invested
  • ROI = E39/-D39
  • ROI = 1,350,000/970,000 = 1.4

Step 3 - Calculate IRR

• IRR (Internal Rate of Return) - tells the company the annual interest rate they received on the investment. Specifically, it’s the interest rate that makes the NPV (net present value) of all cash flows from a project equal to zero
  • In Microsoft Excel use the formula “=IRR(-970,000, 630,000, 720,000)”;  the answer is 25%

For the above project,

Cash Invested was (970,000)
Cash Returned was 1,350,000
ROI was 1.4
IRR was 25%

Would this project be approved?

This would depend on the following:

• Contract term, project size, availability of capital
• Customer’s financial strength, strategic value, and potential future growth
• External competition along that fiber route or in that building
• Internal competition from other capital projects that could be approved (a 25% IRR looks pretty good, unless the other projects are returning 75%)