This presentation provides an overview of the basic principles and calculations often used in developing a financial justication analysis as part of a Business Case. Topics covered include: - Pre-Tax Cash Flow - Payback Period - Accounting Terms and Principles - Depreciation Methods - After-Tax Cash Flow - Discounted Cash Flow - Net Present Value - Internal Rate of Return - Modified Internal Rate or Return - Economic Value Added - Packaging the Business Case

1. Business Case Development Core Professional Skills Training Document August, 2011

3. Introduction to Business Case Development

5. What is a Business Case? In its simplest form, a business case is about justifying the investment required by the potential value created. Value Created Investment Required Business Case =

8. Financial Justification

9. Financial Justification Ideally, financial justification provides the “meaningful” monetary statistics necessary to drive a decision.

12. 2. Determine the Financial Metrics to Assess The term Return on Investment (ROI) is often used synonymously with a business case, but there are many terms and metrics to consider. Net Cash Flow: Sum of negative and positive cash flows Simple ROI: Ratio of net cash flow divided by the initial investment Discount Rate: The interest rate (or opportunity cost of capital rate) used in determining the present value of future cash flows. The opportunity cost of capital can either be how much you would have earned investing the money someplace else, or how much interest you would have had to pay if you borrowed money Discounted Cash Flow (DCF): Common method of estimating an investment's present value based on the discounting of projected cash inflows and outflows Simple Payback: The period of time, usually measured in years, required to recover the original project investment and not applying a discount rate Discounted Payback: the period of time, usually measured in years, required to recover the original project investment considering the time value of money NPV : The net present value of expected future cash flows of a project minus the initial project investment IRR : The internal return rate which equates the present value of a project’s expected cash inflows to the present value on its expected outflows – can also be viewed as the expected rate of return on a project Modified IRR (MIRR): The internal rate of return using a reinvestment rate for positive cash flows equivalent to the company’s cost of capital or average rates of return Economic Value Added (EVA): EVA equals Net Operating Profit After Taxes (NOPAT) less the opportunity cost of capital.

21. Time Horizon Considerations - Example 1 Generally, the longer the cash flow horizon the higher the return. Example of 5 vs. 7 Year Horizon: (5 Year Horizon) (7 Year Horizon) NPV = $141 NPV = $303

22. Time Horizon Considerations - Example 2 Anticipated Cash Flow $1.0 M annual savings $2.0 M Initial Investment (Discount Rate = 10%) 3 Year Horizon 0 1 2 3 The time horizon assumed for the ROI analysis can have a significant impact on whether an investment is deemed favorable or not. $1.0 M annual savings $2.0 M Initial Investment (Discount Rate = 10%) 6 Year Horizon 0 1 2 3 4 5 6 Net Cash Flow Simple ROI Payback NPV IRR MIRR $1.0 M 50% 2 $0.49 M 23% 18% $4.0 M 200% 2 $2.36 M 45% 25%

23. Time Horizon Considerations - Example 3 6 Year Horizon $2.0 M annually savings $5.0 M initial investment (Discount Rate = 10%) 0 1 2 3 4 5 6 Anticipated Cash Flow The time horizon assumed for the ROI analysis can have a significant impact on whether an investment is deemed favorable or not. Net Cash Flow Simple ROI Payback NPV IRR MIRR $1.0 M 20% 2.5 ($0.03) M 10% 10% $7.0 M 140% 2.5 $3.71 M 33% 21% 3 Year Horizon $2.0M annually savings $5.0 M initial investment (Discount Rate = 10%) 0 1 2 3

24. Net Cash Flow - Words of Wisdom Set practical expectations on cash flow estimates. OVERAMBITIOUS Your Ambition Is Noteworthy But Not Very Practical

25. 4. Use Accounting View of Cash Flow & ROI Increase Net Income Increase Revenues Decrease COGS Reduce Selling Costs Reduce Distribution Costs Reduce Admin. Costs Increase Gross Profit Reduce Operating Expenses Reduce Net Capital Increase Net Operating Profit Before Taxes Reduce Capital Charges Increase Return on Investment Reduce % Cost of Capital Reduce Working Capital Reduce Fixed Assets Depreciation Reduce Income Taxes Reduce Interest Expense Costs & Revenues Assets & Liabilities A cash flow and ROI analysis must be put into accounting terms.

26. Income Statement - Example The income statement represents the overall revenue, costs, and profit of the organization. Income Statement (000’s) Revenue $2,000 Cost of Good Sold (COGS) ($1,000) Gross Income $1,000 Gross Margin 50% Operating Expenses (SG&A)* ($400) Selling, general, and administrative costs EBITDA $600 Earnings before interest, taxes, depreciation and amortization *Depreciation ($200) Non Cash Expense (*often embedded in SG&A) Operating Income $400 Operating Margin 20% Other Non-Operating Expenses ($20) Other Non Operating Revenue $40 EBIT $420 Earnings before interest and taxes Interest Expense ($50) Net Profit Before Taxes $370 Taxes ($148) Net Income $222 Note that Net Income is not equivalent to Net After Tax Cash Flow Profit Margin 11%

27. Balance Sheet - Example A balance sheet states a company’s assets, liabilities (debt) and equity (net worth), where Assets = Liabilities + Equity. Example: What balance sheet line items do we typically impact? Assets (000’s) Cash $ 42 Securities $ 28 Accounts Receivable $ 166 Inventory $ 490 Prepaid Expenses $ 16 Other Current Assets $ 33 Total Current Assets $ 775 Long Term Investments $ 87 Property, Plant & Equipment $ 760 Less Accumulated Appreciation Intangible Assets $ 100 Other Assets $ - Total Assets $ 1,722 Liabilities Short Term Debt $ 50 Accounts Payable $ 198 Accrued Expenses $ 10 Other Payables $ 63 Current Portion of Long Term Debt $ - Total Current Liabilities $ 321 Long Term Debt $ 500 Total Liabilities $ 821 Equity Capital Stock $ 700 Additional Paid in Capital $ 37 Retained Earnings $ 164 Total Equity $ 901 Total Debt & Equity $ 1,722

28. Financial Ratios Common financial ratios used in evaluating the financial health of an organization. Liquidity - Ability to meet short term obligations 2.4 Current Ratio = Current Assets/Current Liabilities 0.9 Quick (Acid Test) Ratio = (Current Assets - Inventory)/Current Liabilities 0.2 Cash Ratio = (Cash + Marketable Securities)/Current Liabilities $454.0 Working Capital = Current Assets – Current Liabilities Activity - Ability to effectively utilize assets 7.7 Days of Cash = Cash/(Sales/365) 30.3 Average Collection Period (in days) = Accounts Receivable/(Sales/365) 178.9 Days of Inventory = Inventory/(COGS/365) 12.0 Receivables Turnover = Sales/Receivables 2.0 Inventory Turns = COGS/Inventory 1.2 Asset Turnover = Sales/Total Assets Profitability - Ability to generate profit 11.1% Net Profit Margin = Net Income/Sales 50.0% Gross Profit Margin = (Sales - COGS)/Sales 20.0% Operating Profit Margin = (Sales - COGS - SGA)/Sales 12.9% Return on Assets = Net Income/Total Assets = Net Profit Margin x Asset Turnover 30.1% Return on Equity = Net Income/Total Equity Leverage - Ability to protect creditor investment 0.5 Debt to Asset Ratio = Total Liabilities/Total Assets 1.1 Debt to Equity Ratio = Total Liabilities/Total Equity 8.8 Times Interest Earned = Net Income Before Taxes and Interest/Interest Expense

47. Depreciation – Methods Comparison The straight line method is the easiest to compute whereas accelerated methods accelerate the tax benefit by expensing depreciation earlier over an asset’s useful life. Illustration

52. Net Cash Flow After Taxes - Project A Investments must be evaluated on an after tax basis. *Depreciation is a non-cash expense. Calculation assumes $200 is a capitalized investment depreciated over 5 years on a straight line basis and with no salvage value. Financial Analysis Investment Life Span (Years) 0 1 2 3 4 5 Total Cash Inflow $0 $0 $150 $150 $150 $150 $600 Cash Outflows (Assumes Capital in Y0; Expense Y1) ($200) ($100) $0 $0 $0 $0 ($300) Net Cash Flow (Pre-Tax) ($200) ($100) $150 $150 $150 $150 $300 Depreciation (5 Years) $0 ($40) ($40) ($40) ($40) ($40) ($200) Net Operating Profit (Before Tax) $0 ($140) $110 $110 $110 $110 $100 Taxes (40%) $0 $56 ($44) ($44) ($44) ($44) ($120) Net Cash Flow (After Tax) ($200) ($44) $106 $106 $106 $106 $180 Net Cash After Tax Flow $180 Total Investment ($300) Simple ROI (After-Tax Cash Flow) 60%

53. Net Cash Flow After Taxes - Project B Investments must be evaluated on an after tax basis. *Depreciation is a non-cash expense. Calculation assumes $400 is a capitalized investment depreciated over 5 years on a straight line basis and with no salvage value. Financial Analysis Investment Life Span (Years) 0 1 2 3 4 5 6 7 Total Cash Inflow $0 $0 $250 $250 $250 $250 $250 $250 $1,500 Cash Outflows (Assumes Capital in Y0; Expense Y1) ($400) ($100) $0 $0 $0 $0 $0 $0 ($500) Net Cash Flow (Pre-Tax) ($400) ($100) $250 $250 $250 $250 $250 $250 $1,000 Depreciation (5 Years) $0 ($80) ($80) ($80) ($80) ($80) $0 $0 ($400) Net Operating Profit (Before Tax) $0 ($180) $170 $170 $170 $170 $250 $250 $600 Taxes (40%) $0 $72 ($68) ($68) ($68) ($68) ($100) ($100) ($400) Net Cash Flow (After Tax) ($400) ($28) $182 $182 $182 $182 $150 $150 $600 Net Cash After Tax Flow $600 Total Investment ($500) Simple ROI (After-Tax Cash Flow) 120%

57. Results of Poor Financial Analysis MISCALCULATION Perhaps You Will Be Long Gone Before They Realize Your Mistake

62. Modified Internal Rate of Return - Project A In the example below, the MIRR is actually lower than the IRR because the expected reinvestment rate of 10% is lower than the IRR. The MIRR results in a more conservative and realistic expected rate of return Financial Analysis Investment Life Span (Years) 0 1 2 3 4 5 Total Cash Inflow $0 $0 $150 $150 $150 $150 $600 Cash Outflows (Assumes Capital in Y0; Expense Y1) ($200) ($100) $0 $0 $0 $0 ($300) Net Cash Flow (Pre-Tax) ($200) ($100) $150 $150 $150 $150 $300 Depreciation (5 Years) $0 ($40) ($40) ($40) ($40) ($40) ($200) Net Operating Profit (Before Tax) $0 ($140) $110 $110 $110 $110 $100 Taxes (40%) $0 $56 ($44) ($44) ($44) ($44) ($120) Net Cash Flow (After Tax) ($200) ($44) $106 $106 $106 $106 $180 Discounted Cash Flow (using 10%) ($200) ($40) $88 $80 $72 $66 $65 Net Present Value $65 Internal Rate of Return (IRR) 18.7% Modified IRR (w/10% reinvestment rate) 15.1%

63. Modified Internal Rate of Return - Project B In the example below, the MIRR is actually lower than the IRR because the expected reinvestment rate of 10% is lower than the IRR. The MIRR results in a more conservative and realistic expected rate of return Financial Analysis Investment Life Span (Years) 0 1 2 3 4 5 6 7 Total Cash Inflow $0 $0 $250 $250 $250 $250 $250 $250 $1,500 Cash Outflows (Assumes Capital in Y0; Expense Y1) ($400) ($100) $0 $0 $0 $0 $0 $0 ($500) Net Cash Flow (Pre-Tax) ($400) ($100) $250 $250 $250 $250 $250 $250 $1,000 Depreciation (5 Years) $0 ($80) ($80) ($80) ($80) ($80) $0 $0 ($400) Net Operating Profit (Before Tax) $0 ($180) $170 $170 $170 $170 $250 $250 $600 Taxes (40%) $0 $72 ($68) ($68) ($68) ($68) ($100) ($100) ($400) Net Cash Flow (After Tax) ($400) ($28) $182 $182 $182 $182 $150 $150 $600 Discounted Cash Flow (using 10%) ($400) ($25) $150 $137 $124 $113 $85 $77 $261 Net Present Value $261 Internal Rate of Return (IRR) 24.4% Modified IRR (w/10% reinvestment rate) 17.7%

65. Example Financial Analysis – ROI Inputs Example The input parameters are illustrated in the ROI template below:

66. Example Financial Analysis – Depreciation

67. Example Financial Analysis – ROI Outputs Example

69. EVA - NOPAT from Income Statement The Net Operating Profit After Taxes (NOPAT) is the operating income less the taxes associated with the operating income. Example: Non-operating costs and revenues, and their proportional taxes, are excluded from NOPAT. Example Income Statement Revenue $2,000 Cost of Good Sold (COGS) ($1,000) Gross Income $1,000 Gross Margin 50% Operating Expenses (SG&A)* ($400) Selling, general, and administrative costs EBITDA $600 Earnings before interest, taxes, depreciation and amortization *Depreciation ($200) Non Cash Expense (*often embedded in SG&A) Operating Income $400 Also referred to as EBIT Operating Margin 20% Other Non-Operating Expenses ($20) Other Non-Operating Revenue $40 EBIT $420 Earnings before interest and taxes Interest Expense ($50) Net Profit Before Taxes $370 Taxes (40%) $148 Net Income $222 Profit Margin 11% NOPAT $240 Net Operating Profit After Tax = Operating Income * (1-Tax Rate)

70. EVA - NOPAT from Project The Net Operating Profit After Taxes (NOPAT) is different than cash flow because it includes the non-cash flow expense of depreciation. Example Project NOPAT 0 1 2 3 4 5 Marginal Savings $ - $ 2,000 $ 2,000 $ 2,000 $ 2,000 $ 2,000 Marginal Costs & Project Expenses $ - $ (1,000) $ (1,000) $ (1,000) $ (1,000) $ (1,000) Net Savings (pre Depr. & Taxes) $ - $ 1,000 $ 1,000 $ 1,000 $ 1,000 $ 1,000 Depreciation Expenses (non Cash) $ - $ (2,286) $ (3,804) $ (2,534) $ (1,700) $ (1,380) Net Operating Profit (pre-Taxes) $ - $ (1,286) $ (2,804) $ (1,534) $ (700) $ (380) Income Taxes $ - $ 514 $ 1,122 $ 614 $ 280 $ 152 Project Net Operating Profit After Taxes $ - $ (772) $ (1,682) $ (920) $ (420) $ (228) Cash Flow from Operations $ - $ 1,514 $ 2,122 $ 1,614 $ 1,280 $ 1,152

74. EVA – Project Example The example below illustrates the EVA calculation for project investment.

78. Questions? Questions The Answer To A Good Question Can Illuminate A Room Full Of Dim Bulbs