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PMI Virtual Library

2014 Bill Kay

Six Questions on the Path to Financially


Justified Projects: Developing Cash Flow
Models
By Bill Kay, MSOL, PMP

Abstract
Projects are financial and strategic investments that exist to deliver value. Cash flow modeling is a required and essential
step to produce return on investment (ROI) financial measurements that support the project selection process. Examined
are finance topics, specifically six key questions non-financial personnel need answered at the onset of the process if they
are to produce reliable and accurate cash flow models to transform the project manager into a strategic value-enabler and
profit creator.

rojects are financial and strategic investments initiated


to improve shareholder value and can only be
successful when they deliver their expected business
returns. Senior leaders, the executives above the project level
realize this, think in these business terms, and crave financial
information for decision purposes. To be a strategic valueenabler and profit creator a project manager must be capable
of conveying the big picture of their projects in business and
financial terms. Developing these skills will enhance your
ability to manage the delivery of value.
Lets begin with a hypothetical business scenario. Youre
working on a big project. Its one-third complete. The
company hires a new CFO, and in an effort to get up to
speed quickly, a meeting is called. You are asked to review
the potential project results because the investment required
for this particular project is quite large. Are you prepared
to discuss your projects ROI financial measurements (e.g.,
ROI, IRR, NPV, Payback) or will you freeze like a deer
in headlights? Did you prepare a cash flow model that
summarizes your projects financial value to the organization,
financial projections that your superiors are likely to take
seriously? Without this knowledge, how do you really know
if you are using corporate funds and resources wisely?

Project professionals are quite proficient at managing


project managements triple constraints (scope, cost, and
schedule), yet they often fail to grasp the big picture. Often
the thrust of their efforts is on project execution, when it
should be (more appropriately so) on value attainment. By
sharpening your understanding of basic financial concepts,
you can greatly improve your ability to project and articulate
project benefits in quantifiable business returns.
If your project is not in alignment with the organizations
financial and strategic goals, simply stated: why bother? For
this reason, the knowledge and skills needed to quantify
projected returns are imperative for any successful project
manager. This article aims to acquaint project managers
with the information and knowledge required initially, and
in advance of, efforts to build a cash flow model. The intent
is to increase comprehension and make developing models
a lot less arduous, eliminating many of those I dont know
how to proceed roadblocks. Armed with this knowledge,
you will be one step closer to producing an accurate financial
representation of your project.
You will need to know the following:
What is the accounting method used for
depreciating assets?
To calculate key financial measures needed to assess a projects
value contribution requires that you identify project assets
and determine if, and how, they should be depreciated. To
account for depreciation, a well-developed financial model
must reflect depreciation expenses for assets purchased/placed
in service by the project.
Generally accepted accounting principles (GAAP), which
vary from country to country, represents the standard in the
United States for creating financial reports. The standards
require that the value of an asset be expensed allocated, over
the useful life of the asset (i.e., over the time that it is used
to generate revenue and profits) according to The Matching
Principle, which essentially allows for a more objective
analysis of profitability.
The Matching Principle is a fundamental accounting
rule in which the income or revenue (cash inflows) match
up with associated expenses (cash outflows) to determine
profits in a given period of timeusually a month, quarter,
or year. In other words, cost is recognized (for accounting
purposes) at the time when the benefit that the cost provides
occurs. This differs from when the actual expense occurs
during project execution. The theory surrounding this is
simple. For example, if your project requires the purchase
of a specialized piece of equipment, which is expected to

generate revenues over the coming five years, it makes sense to


allocate (match) via a depreciation schedule, the purchase cost
of the equipment over the given time period it is expected
to produce revenue. Done differently, the numbers on the
organizations income statement could result in misleading or
false conclusions.
There are different accounting methods an organization
can use to depreciate assets. The more common methods
include straight-line, fixed percentage, and declining balance,
with straight-line being the most common and the easiest to
use method. With straight-line, the original asset cost, less its
salvage value (at the end of its useful life) is expensed in equal
increments over its depreciable period. Assets may or may
not have an estimated salvage value at the end of its useful
life. For example, a depreciation expense of $12,000 per year
($1,000/month) for 5 years using straight-line depreciation
may be recognized for an asset that costs $60,000 with no
salvage value at project completion. The depreciation expense
becomes a write off (over the assets anticipated life) against
profits in the same period.
Depreciable assets include equipment and other tangible
assets. Computing depreciation may vary according to the
asset class, accounting standards, length of the depreciable
lives of the assets, or the tax laws of a particular country.
Supplies, and other such items considered to be used within
one single year cannot be depreciated, and are expensed
during that year.
The ability to expense an asset is useful for tax purposes.
Generally, the cost is allocated as depreciation expense.
Depreciation is a noncash expense and therefore reduces the
total tax liability for the proposed project. Obviously, this is a
good thing, since depreciation lowers reported earnings while
increasing free cash flow.
What is your companys income tax rate?
Taxes are a real expense, have a significant impact on project
results, and consequently lower overall financial benefits that
projects achieve. For this reason, cash flow models are built
on an after tax basis. After-tax cash calculations are needed to
discount future payoffs (future cash inflows) to present values,
which in turn provide the means to calculate additional
metrics youll require.
If your firms tax rate is 30%, a $350,000 operating gain
generated by a project becomes $245,000 once taxes are taken
out. However, if that income tax rate was 35%, the $350,000
financial gain then becomes only $227,500 ($17,500
difference no longer contributing to bottom line results).
There may be time-period(s) when the project loses money, in
which case the appropriate tax rate is applied to the operating

PMI Virtual Library | www.PMI.org | 2014 Bill Kay


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loss, thus lowering the tax liability. Reflecting the impact of


taxes produces ROI financial measurements that are more
precise. You will therefore want to know your firms tax rate.

funds. The average of these rates is the blended rate. This


blended (interest) rate represents the cost of debt to the
company expressed as a percentage.

What is the payback period?


Payback period, also known as time-to-money period, is a
measure of risk and more aligned with organizational liquidity
than anything else. The longer the payback period, the riskier
the project becomes. A risk adverse company may have a
smaller payback period stipulation, perhaps a cutoff period of
less than two years, than one more tolerant and open to more
risk.
If your company has established risk tolerance parameters
around payback periods, you will want to know this. Your
project may be cut off from further analysis before it even gets
off the ground.

Equity
Equity represents another source (and more costly form) to
fund projects and business operations. Corporations can
secure funds by selling stock (or by utilizing retained earnings
from business operations, another form of equity). In return
for their investment dollars, shareholders receive ownership
interest in the company, but they also expect a reasonable (or
better), financial return on their investment (e.g., stock price
appreciation, dividend payouts). Company directors may
know that if the company provides an overall annual return
to investors (of some amount, lets say 8%) they are likely to
remain happy and to stay as investors. Companies must meet
the financial expectation of shareholders; otherwise, they will
unload their shares, causing the stock price to drop. This is
the cost of equity (also expressed as a percentage), and is
essentially what it costs the company to maintain a share price
theoretically acceptable to investors, e.g., the 8%.

What determines whether a given cost is a


capital expenditure or an operating expense?
Capital expenditures (most) are depreciable assets, and
operating expenses are not. The difference, the relevance to
your project is this: operating expenses directly reduce profit
by showing up on your projects income (cash flow) statement.
Whereas with capital equipment only the depreciation appears
on the income statement, the capital expenditure (the large
layout of cash) shows up on the balance sheet.
Organizations generally consider an asset depreciable if it
is greater than a specified dollar amount. Submitting project
financials that align with company policy is the reason why
you will want to address this question.
Do you know your companys weighted average
cost of capital (WACC)?
Ever get curious about where the money comes from to fund
projects once approved? Companies fund projects (and other
areas of the business) by one of two primary means: debt
and equity, or a combination of both. Lets explore debt
and equity first, as this will help solidify your understanding
and comprehension of the financial metric introduced in the
above subtitle.
Debt
Debt is borrowed money. Financial institutions (the most
common debt financing source) lend companies the money
that often finances projects. The loan(s) could be in the
form of a revolving credit line, or issued as a direct loan(s).
Companies incur interest rate charges on the various loans
they acquire and/or the corporate bonds they issue. The
interest rate may vary across the various sources of these

Capital Structure
For reasons not relevant here, some businesses find that it
makes more sense to purchase items by incurring debt (bank
loans), and for others, to use cash (equity financing, selling
stock). The balance between debt and equity funding signifies
the companys capital structure; it represents the percentage of
debt and percentage of equity a company maintains to fund
its projects and run day-to-day business operations. Capital
structure can vary greatly from one company to another or
from one industry to another (e.g., 30% debt to 70% equity
structure for one company and 50% debt to 50% equity
structure for another, or variations thereof ).
Weighted Average Cost of Capital and its Relevance
We are now ready to explore the financial metric called
weighted average cost of capital. WACC is a measurement
that refers to the capital structure of a company. It is a
proportionately weighted calculation that brings together the
weighted cost of debt and the weighted cost of capital (into
one number) used to express an overall interest rate for a
company to meet its obligations to financial institutions and
shareholders. For example, WACC = 14.75%.
A specific company may have a 30% debt capitalization
at 8.2% (the blended interest rate) and a 70% equity
capitalization at 14% (rate shareholders kept happy, remain
as investors). It is from these numbers the WACC is derived.
Note: The required rate of return on debt is after tax.

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Keep in mind, WACC is also descriptive of company risk


(not to be confused with project risk), as smaller firms are
less likely to secure the same debt financing terms, i.e., the
lowest possible rates, as larger and perhaps more creditworthy
organizations. The business reality of higher opportunity
costs (higher risk) reflects in the blended (debt) rate and in
stockholders higher requirements, and then finally in the
WACC calculation itself. Stable companies, for example
Walmart, will have a lower WACC representative of lower
risk and therefore a lower hurdle rate to jump over when
approving projects.
Perhaps we have arrived at the Ah ha moment,
understanding the relevance of WACC to the project
manager. When developing a discounted cash flow valuation
model, WACC is used as a discount rate to derive a projects
net present value (NPV). NPV conveys the financial value
a project brings to the organization in todays dollars from
the anticipated future cash flows. If the borrowing rate is
14.75%, the project submitted for approval must have a yield
greater than this for it to be profitable. The projects financial
return or internal rate of return (IRR) must be greater than
the money being borrowed to fund the project.
What is the hurdle rate your company uses?
No company has an unlimited source of funds from
which to execute its strategy. It stands to reason that with
limited funds available, those projects funneled through the
selection criteria must be profitable if the organization is to
achieve its intended strategy. This limitation imposes upon
the organization the need to make thoughtful, calculated
decisions concerning what projects receive funding approval.
A key component of this decision process is a companys
selection of their expected/required rate of return, or the
hurdle rate that must be achieved to make projects a
worthwhile investment in their particular business setting.
To make it worthwhile, project investment returns
always need to be higher than the cost of capital. The WACC
(percentage) represents the cost of capital, and is used (most
often) as the hurdle rate, but not always. If used as the
hurdle rate to make and evaluate investment decisions, the
WACC would represent the minimum required rate-of-return
at which a company produces value for its investors. The
WACC is appropriately used as the hurdle rate if you are
confident the promised future cash flows will be received.
Many finance professionals assume that the historical
WACC is automatically the correct discount rate with which
to assess a prospective projects NPV. This assumption is

incorrect; the companys WACC should not extend to all


projects. What matters most is the relative risk profile of the
specific project under consideration, and its ability to generate
net free cash flow that is certain. While risky projects may
provide leapfrog advantages to an organization, overall risk
increases and financial certainty fades, as future cash flow
estimates are likely to be flawed (e.g. high probability of cost
overruns). When project risk is higher than the companys
existing complement of average or typical undertakings as
reflected in its historical WACC, a project risk premium
should be added to the companys cost of capital. This
provides a hurdle rate equal to the companys cost of capital
plus the projects risk premium.
This protective measure employed by the company
compensates for accepting the added risk by requiring a riskadjusted rate of return. The profitability expressed by the NPV
calculation is lowered and the chance of accepting the project
is also lowered. Evaluating alternatives by requiring a higher
rate tilts results in favor of selecting profitable projects, while
eliminating from consideration marginally profitable projects.
The inevitable tradeoff here is between realizing an opportunity
loss versus realizing a real loss. In the latter situation, there is
a real economic loss and the company is shedding value.
Risk premiums can vary from less than one percent
to several percentage points; and inversely, especially-lowrisk projects may warrant a downward adjustment in the
WACC to account for the risk differential. Establishing
the hurdle rate(s) has more to do with careful reflection
and forward-looking vision than a finance department
formula. Influencing factors, assumptions, or judgments
might include the economic horizon, competitive forces,
industry conditions, type of financing anticipated, risk
tolerance (obviously a major factor), faith in the accuracy of
the estimates, and the companys overall situation (e.g., cash
position/liquidly).
Conclusion
Always consult your finance department or CFO on these
important questions and any appropriate method(s) or
guidelines specified within your organization. Armed with
this knowledge, you are likely to build cash flow models your
superiors will take seriously. Furthermore, it will demonstrate
understanding and show initiative on your behalf and you will
likely earn considerable credibility with that department (or
other key decision makers) which incidentally, may ultimately
have final word, or control the purse strings on your current
(or future) project.

PMI Virtual Library | www.PMI.org | 2014 Bill Kay


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Works Consulted
Berman, K., Knight, J. & Case, J. (2006). Financial
intelligence: A managers guide to knowing what the numbers
really mean. Boston, MA: Harvard Business School
Publishing.
Callahan, K. R., Stetz, G. S., & Brooks, L. M. (2007).
Project management accounting: Budgeting, tracking, and
reporting costs and profitability. Hoboken, NJ: John Wiley &
Sons, Inc.
Resch, M. (2011). Strategic project management
transformation: Delivering maximum ROI & sustainable
business value. Fort Lauderdale, FL: J. Ross Publishing Inc.

About the Author

Bill Kay, MSOL, PMP, has 35 years of experience as an


entrepreneurial leader in operations, process re-engineering,
and project management. He is focused on solving business
challenges and identifying opportunities to increase a
companys efficiency, organization, growth, and profitability.
Mr. Kay graduated with honors from Regis Universitys
College of Professional Studies, Denver, Colorado, with
a Master of Science in Organization Leadership: Project
Leadership and Management Degree, and a Graduate
Certificate in Strategic Business Management. He earned his
Bachelors degree from William Paterson University of New
Jersey. He is a Project Management Professional (PMP)
credential holder and active member of PMIs Atlanta
Chapter. His LinkedIn and Google profile can be viewed at
https://www.linkedin.com/in/billkay.

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