1. Feasibility Study, Cost Analysis and Capital Budgeting Asst. Prof. Dr. Chanin Yoopetch

2. feasibility study When to do a feasibility study? Before starting a new business The process of defining a new business is critical. A feasibility study is an important tool for making the right decisions. A wrong decision at this point often leads to business failure. Only 50% of startups are still in business after 18 months, and only 20% are in business after 5 years.

3. feasibility study What exactly is the project? Is it possible? Is it practicable? Can it be done? Economic feasibility, technical feasibility, schedule feasibility, and operational feasibility - are the benefits greater than the costs? Technical feasibility - do we 'have the technology'? If not, can we get it? Schedule feasibility - will the system be ready on time? Customer profile: Estimation of customers/revenues. Operational feasibility - do we have the resources to build the system? Will the system be acceptable? Will people use it?

4. feasibility study Five common factors (TELOS) Technology and system feasibility This involves questions such as whether the technology needed for the system exists, how difficult it will be to build, and whether the firm has enough experience using that technology. This can be quantified in terms of volumes of data, trends, frequency of updating, etc in order to estimate if the new system will perform adequately or not.

5. feasibility study Five common factors (TELOS) Economic feasibility Economic analysis is the most frequently used method for evaluating the effectiveness of a candidate system. More commonly known as cost/benefit analysis, the procedure is to determine the expected benefits and compare them with costs. If benefits outweigh costs, then the decision is made to design and implement the system.

6. feasibility study Five common factors (TELOS) Legal feasibility Determines whether the proposed system conflicts with legal requirements.

7. feasibility study Five common factors (TELOS) Operational feasibility Is a measure of how well a proposed system solves the problems, and takes advantages of the opportunities identified during scope definition and how it satisfies the requirements identified in the requirements analysis phase of system development.

8. feasibility study Five common factors (TELOS) Schedule feasibility A project will fail if it takes too long to be completed before it is useful. Typically this means estimating how long the system will take to develop, and if it can be completed in a given time period using some methods like payback period. Schedule Feasibility is a measure of how reasonable the project timetable is.

9. Elements of a Feasibility Analysis Financial Feasibility Industry and Market Feasibility Product or Service Feasibility

10. Cost-Benefit Analysis (CBA)

11. Plan of Discussion What is Cost-Benefit Analysis? What are some alternatives to CBA?

12. What Is Cost-Benefit Analysis (CBA)? The key objective is to determine whether the benefits of a policy or program or project exceed its costs How does this differ from private sector investment analysis? A broader perspective is used—society as a whole It is often more difficult to put values on outcomes

13. Basic Steps in CBA 1.Decide whose benefits and costs count 2.Select the portfolio of alternatives 3.Catalogue (potential) impacts and select measurement indicators 4.Determine impact quantities over the life of the project

14. Basic Steps in CBA (Continued) 5.Monetize impacts 6.Chose the discount rate 7.Add up the benefits and costs 8.Perform sensitivity analysis 9.Recommend the alternative with the largest net social benefits

15. (1) Decide Whose Benefits and Costs Count This is called the “standing” issue Who should have standing in the CBA?

16. (2) Select the Portfolio of Alternatives A change in policy(new project) must be compared with the existing policy What is wrong with a current policy or project?

17. (3) Catalogue Potential (Physical) Impacts and Select Measurement Indicators ‘Impacts’ refers to both inputs (costs) and outputs (benefits) Beneficial impacts examined in the CBA included increases in tax payments, increases in earnings and fringe benefits Cost impacts included staff time and materials Measurement indicators and impacts specified simultaneously Outcomes???

18. (4) Determine Impact Quantities Over the Life of the Project This step usually requires predictions of how long impacts will last and how they vary over time This is often very difficult to do accurately EXAMPLES from the CBA Corporate Earnings Per capita income

19. (5)Attach Money Values to All Impacts Very important step Must be done to make all impacts “commensurable,” thereby allowing them to be summed Example from evaluation Staff time Sometimes difficult to do Value of time spent Value of life

20. (6) Choose the Discount Rate Needed because some benefits and costs occur in the future Use of a discount rate makes benefits and costs that occur in different time periods commensurable It is used to compute present values The appropriate rate to use is controversial 5% 8% 10%?

21. Formula for Net Present Value (NPV) Where B t = benefits over time C t = costs over time r = the social discount rate t = a time period

22. (7) Sum the Benefits and Costs Decision rule if all benefits and costs occur in the same time period: If net benefits = B – C > 0, adopt new program If net benefits = B – C < 0, stay with status quo Decision rule if benefits and/or costs occur in different time periods, as in the evaluation: If NPV = PV(B) – PV(C) > 0, adopt new program If NPV = PV(B) – PV(C) < 0, stay with status quo

23. (8) Perform Sensitivity Tests Sensitivity tests involve attempts to see if the results are robust to alternative assumptions The sensitivity of NPV to a change in that factor is then observed (calculated as Δ NPV / Δ factor). For example, the analyst will set annual revenue growth rates at 5% for "Worst Case", 10% for "Likely Case" and 25% for "Best Case" – and produce three corresponding NPVs.

24. (9) Recommendations The project or option with the largest net benefits(or other benefits) should be adopted Do nothing is always an option!!

25. Alternatives to ‘Pure’ CBA ‘Pure’ CBA is only possible If all the benefits and costs can be measured If all the benefits and costs can be monetized If this isn’t possible, an alternative to pure CBA must be used Two possible alternatives are: Qualitative CBA Cost-effectiveness analysis

26. Qualitative CBA Probably much more frequently used than pure CBA It works as follows: The evaluator first obtains monetary measures for all benefits and costs for which this is possible Then, the remaining benefits and costs are assessed as well as possible For example, if feasible, they are quantified Some qualitative aspects; non-monetary outcomes (e.g., social cohesion, high school graduation, implications of increased employment)

27. Cost-Effectiveness Analysis (CEA) CEA can be used if all benefits and costs are quantified, but some aren’t monetized It is an attempt to get around putting a monetary value on all project impacts Often used in the health and educations fields, where it is difficult to put a monetary value on some impacts

28. Example of CEA: Tourism investment and Benefits In CBA, a monetary value would be put on each project B/C = Per capita Income of villagers/ Cost in dollars = Dollars of benefits per dollar of expenditure In CEA, a monetary value is not placed on quality of lives C/E = Cost in dollars / Number of lives having better quality of life = Number of dollars expended per life having better QoL

29. Cost-Utility Analysis cost-utility analysis Specifically, the effects of Tourism investment on the length of life and on the quality of life are combined into something called QALYs— Quality-Adjusted Life-Years Idea is to allow a policy that provides people with 10 years of enjoyable life to be ranked higher than a policy that keeps people alive for 10 years as vegetables, even if the first policy costs more

30. Summary of Cost Analysis Involves measuring expenditures on the resources required to operate a program Uses Essential for CBA Helpful in monitoring and modifying on-going programs However, depending on circumstances, there are a variety of ways of determining costs

31. Relevant cash flows Project Cash Flow Analysis

32. Cost: $200,000 + $10,000 shipping + $30,000 installation. Depreciable cost $240,000. Inventories will rise by $25,000 and payables will rise by $5,000. Economic life = 4 years. Salvage value = $25,000. Proposed Project

33. Incremental gross sales = $250,000. Incremental cash operating costs = $125,000. Tax rate = 30%. Overall cost of capital = 10%.

34. 01234 Initial Outlay OCF 1 OCF 2 OCF 3 OCF 4 + Terminal CF NCF 0 NCF 1 NCF 2 NCF 3 NCF 4 Set up without numbers a time line for the project CFs.

35. = Corporate cash flow with project minus Corporate cash flow without project Incremental Cash Flow

36. Capital Budgeting Payback Net present value (NPV) Internal rate of return (IRR)

37. What Is capital budgeting? Analysis of potential additions to fixed assets. Long-term decisions; involve large expenditures.

38. Steps 1. Generate ideas. 2.Estimate CFs (inflows & outflows). 3.Assess riskiness of CFs. 4.Determine k = WACC 5.Find NPV and/or IRR. 6.Accept if NPV > 0 and/or IRR > WACC.

39. Normal Project Cost (negative CF) followed by a series of positive cash inflows. Nonnormal Project One or more outflows occur after inflows have begun. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine.

40. Inflow (+) or Outflow (-) in Year 012345NNN -+++++N -++++- ---+++N +++--- -++-+-

41. What is the payback period? The number of years required to recover a project’s cost, or how long does it take to get our money back?

42. Payback for Project L 108060 0123 -100 CF t Cumul -100-90-3050 Payback L = 2 + 30/80 = 2.375 years. 0 2.4

43. = 2 + 41.32/60.11 = 2.7 years. -41.32 60.11 108060 0123 CF t Cumul -100-90.9118.79 Disc. payback Discounted Payback: Uses discounted rather than raw CFs. Apply to Project L. PVCF t -100 10% 9.0949.59 Recover invest. + cap. costs in 2.7 years. 2.7

44. Sum of the PVs of inflows and outflows. Net Present Value (NPV) If one expenditure at t = 0, then NPV =  n t=0 CF t (1 + k) t NPV =  - CF 0. n t=1 CF t (1 + k) t

45. What is Project L’s NPV? 108060 0123 10% Project L: -100.00 9.09 49.58 60.11 18.78 = NPV L NPV S = $19.98.

46. NPV= PV inflows - Cost = Net gain in wealth. Accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Adds most value. Rationale for the NPV Method

47. Internal Rate of Return (IRR) 0123 CF 0 CF 1 CF 2 CF 3 CostInflows IRR is the discount rate that forces PV inflows = cost. This is the same as forcing NPV = 0.

48. NPV:Enter k, solve for NPV. IRR:Enter NPV = 0, solve for IRR.  t n t t CF k NPV     0 1.

49. What is Project L’s IRR? 108060 0123 IRR = ? -100.00 PV 3 PV 2 PV 1 0 = NPV Enter CFs in CFLO, then press IRR: IRR L = 18.13%.IRR S = 23.56%.

50. Practice Quantify at least three-four benefits of your current project

51. The End