In my last article (The Sunday Times, May 20), I wrote on how to carry out an honest assessment of key personal and situation specific attributes that enhance the probability of success for an entrepreneurial venture.
Throughout my articles, I have been referring to an example of a software programmer who has just developed an innovative mCommerce solution targeted specifically at fast food service providers.
Regardless of your specific situational context however, the success of a venture is highly contingent upon its economic and financial viability denoted by a satisfactory return on investment. There are a host of methods that could be deployed when measuring your return on investment.
One of the most widespread techniques, used by accountants and generally required by financial institutions when considering financing applications of enterprises, is the Discounted Cash-flow Analysis method. The analysis may become very complex, and it is recommended that you hire a qualified accountant to support you in the process.
This notwithstanding, you need to understand the basic concepts of the technique not only to become a knowledgeable consumer of the information and advice being provided by your accountant but also to be in a position to reasonably challenge and seek appropriate explanations for the results being presented.
Simplistically, there are four key sources of data that need to be populated for the purpose of constructing a traditional feasibility study using discounted cash flow analysis. These include investment outflows, cash inflows, operating outflows and the weight average cost of capital.
In our analysis, we shall be including a fifth variable, which is the opportunity cost of leaving your current career. Please note that all references to figures, results and assumptions used in this exercise are for illustrative purposes only and should not be construed as providing an accurate assessment of the feasibility of the project.
The objective of this exercise is to illustrate the use of the discounted cash flow technique to become knowledgeable consumers of financial information. Moreover, it is also recommended that you refer to a trusted financial advisor who has the knowledge, qualifications and experience to support you in carrying out the relevant feasibility study.
Cash inflows primarily consist of revenue generated from the sale of your innovative products or services. In the case of our software developer, we had established through the evaluation of the market opportunity that the latter could expect to generate revenues in the region of €1.4 million in the first year, increasing progressively at a constant rate reaching €23.5 million in the fifth year of operation.
For simplicity's sake, we shall assume that all sales are cash-based such that cash inflows are equal to sales revenues. In practice, you may need to take into account debtors since clients would require you to provide them with appropriate credit terms. On the basis of these assumptions, a forecast of cash inflows for our software programmer may be derived.
The revenues being generated have to be supported by an adequate capital investment required to support the infrastructure necessary to develop and build the capacity to handle the demand for these services. Capital investment may be divided into a number of categories. Key categories may include:
• Land and building: These include all immovable property required to house your operations, administration, marketing and distribution functions of your organisation. The capital expenditure on land and buildings may be prohibitive in the initial stages, such that it may be more appropriate to rent as opposed to buying your own premises.
Depending upon the lease agreement, renting out premises in the initial stages, may provide the entrepreneur with some flexibility in moving from one place to another whenever the existing space does not support current and future demand levels without going through the normal buying and selling pains.
On the other hand, however, most lease agreements do not entitle the tenant to any ownership rights over the property such that the tenant does not benefit from proceeds realised from the sale of the property.
A third option which could also be considered is the conversion of a room in your dwelling into an office that could serve as an initial base from where you could start your business. This will however depend on the nature of your business.
In the case of our software programmer, he envisages to rent out a 500 m2 office capable of hosting a manpower complement of 20 people in the UK. Assuming an average rental fee of €200 per m2, the annual rent is expected to amount to €100,000 per year.
• Furniture and fittings: This includes expenditure related specifically to the refurbishment of property and related finishings and furniture. The software programmer expects to furnish the premises to be rented out with a capital outlay of €50,000.
• Plant and equipment: Plant and equipment include all assets that need to be deployed by an enterprise for the purpose of manufacturing, processing and storing a product and/or service being provided to the consumer. Once again, equipment may be either bought or leased out from third parties.
This notwithstanding the leasing of equipment, is not a very common practice in Malta, with most enterprises buying directly their equipment to be used in production. The amount of capital expenditure on equipment depends considerably upon the nature of the operation, but it also depends on the entrepreneur's operations strategy.
More specifically, the entrepreneur may have to choose between placing more reliance on the work force (labour intensive) or doing away with a smaller labour force at the expense of higher costs incurred in equipment (capital intensive).
In the case of our software programmer, he estimates that his initial investment in computer equipment will be in the region of €500,000 mostly comprising of PCs, services and hand-held devices. Maintenance costs are envisaged to amount to two per cent of the cost of the equipment on a yearly basis.
• Computer software: This includes all software programmes that are acquired by an entity for the purpose of managing the information system supporting the products or services being provided by an entity.
While being a capital expense, computer software needs to be typically supported by maintenance and troubleshooting services being provided by suppliers to attend to any breakdowns in the system that may occur during the lifetime of the software.
Moreover, given the continuous advancement being experienced in computer software, this frequently needs to be subject to expenses associated with upgrades in line with new developments within the system. In the context of our software programmer, he has already developed the required software in house.
This notwithstanding the programmer feels that he still needs an additional six months of work on a full-time basis to reach the commercialisation stage.
At an assumed charge out rate of €50 per hour and total man hours of work equivalent to 1,040, the estimated investment required for the purpose of commercialising the software programme amounts to €52,000.
The software programmer however has been working on this project for the past two years. During this period he has engaged the services of four junior programmers on a full-time basis to support him in the process. He estimates that the total investment (in terms of man hours of work) amounts to €400,000.
The distinct between prior and future work is important. Prior work represents a sunk cost that may not be recovered, and is therefore irrelevant for the point of view of the software programmer to decide whether to commercialise his business idea or not. On the other hand, the software programmer would need to include prior work in his calculations when seeking sources of financing from third parties, especially since a proportion of equity stakes may need to be negotiated with the latter.
• Motor vehicles: Until a few years ago, the leasing of vehicles was highly popular by the business community in Malta. Following the issue of fringe benefit regulations as well as changes in income tax legislation however, such a practice has become less commonplace.
For the purpose of the case study, the software programmer shall lease a fleet of five cars to be increased to ten in the third year of operation. The annual lease payments include maintenance, insurance and road licences amounting to €1,000 per annum per car, excluding fuel. Such payments are of an operational nature and are not included as part of the capital investment.
In addition to the initial capital investment, an organisation would need to incur ongoing costs associated with the day-to-day running of the business. The key cost categories include:
• Direct operating outflows: These consist of expenses directly associated with the provision of products and/or services to your clients. Direct operating costs typically include material costs (made up of raw materials, work-in-progress and finished goods), labour costs (consisting of wages and salaries, overtime, allowances) and direct overheads.
In the case of the software programmer, six technicians (each with an average salary of €50,000) and two software developers (each earning €80,000) will be recruited with a total wage bill amounting to €460,000 in the first year.
An additional technical and two additional software developers are expected to be recruited each year during the five years such that the wage bill in the fifth year would amount to €1.3 million. Overheads include the rental of premises, leasing of vehicles as well as maintenance of hardware.
• Marketing expenses: These constitute all costs associated with the market research, promotion, advertising, selling and distribution of products and services being provided by an organisation in its day-to-day operation. Marketing budgets are typically set as a percentage of forecast turnover for the period. In the context of the software programmer, marketing expenses have been set at 10 per cent of the expected turnover per year.
• Administrative expenses: Administrative expenses consist of general expenses which do not contribute directly to the production, financing and/or selling of an organisation's product or service.
Typical examples of administrative expenses include professional fees, audit fees, water and electricity, general rent and rates amongst others. The software programmer estimates that total administrative expenses for his venture will amount to €40,000 per annum.
A fourth variable required to derive your discounted cashflow analysis is your cost of capital frequently referred to as the discount rate.
The cost of capital may be defined as the rate of return that could be earned in the capital market on securities of equivalent risk. The cost of capital is comprised of three factors, namely a risk-free rate, inflation and a risk premium associated with the risk profile of the venture.
In general, the higher the risk of the entrepreneurial firm's activities, the higher is its cost of capital, since investors typically require compensation for greater risk. For entrepreneurial ventures financed by debt and equity, the cost of capital will be a weighted average of its cost of capital from both sources.
Entrepreneurial ventures are characterised by a high level of uncertainty. By definition, unlike risk, uncertainty cannot be measured and hence the determination of a cost of capital is highly subjective requiring the intervention of accountants and relevant industry experts.
In our case study, the software programmer has engaged the services of an accountant and a mobile solutions industry expert to support him in carrying out an investment appraisal of his proposed entrepreneurial venture.
As part of their work, the accountant with the help of the mobile solutions industry expert has estimated the cost of capital to be in the region of 30 per cent, assuming full financing from own resources.
Finally, to complete our analysis, entrepreneurs also need to take into account the opportunity cost associated with foregoing their current employment as well as their future career prospects.
The setting up of an entrepreneurial venture may come at the expense of your existing career development, which essentially guarantees access to a fixed stream of income on a monthly basis.
Moreover, your present employment may present lucrative prospective for career progression which further enhances your earnings potential.
Paradoxically, therefore an established career and a high level of current and future potential employment earnings increase your opportunity cost and make the option to set up your own entrepreneurial venture less attractive.
The software programmer depicted in this case study is presently employed by a well established company in Malta with an earnings package of €30,000.
The programmer also estimates that his earnings potential could increase up to €50,000 within the next four years in view of a prospective promotion that he has been promised by his employer provided that specific targets are met.
The setting up of an entrepreneurial venture would require the programmer to forgo these earnings and future career prospects.
It is important to note that this variable would need to be excluded when presenting the feasibility study to prospective investors, since this is irrelevant in their context.
We now have all the necessary information required to carry out a simple discounted cash flow analysis. Two versions of discounted cash flow analysis of the same project are produced.
The first reflects the entrepreneur's decision on whether to pursue his initiative to commercialise his idea. This second statement represents the attractiveness of the venture for an outside investor. The entrepreneur would need to carry out both computations.
The analysis reveals that on the basis of the forecasts made by the software developer, his innovative enterprise solution appears to be a highly lucrative venture generating a net present value of €11.2 million, thereby raising a case for terminating employment in his present career for the purpose of pursuing his entrepreneurial venture. Moreover, the enterprise also appears to be attractive for prospective investors with a net present value of €10.92 million.
This article has demonstrated how you can carry out a simple investment appraisal of your business model using discounted cash flow analysis techniques.
However, it must be reiterated that all assumptions and numerical representations have been used for illustrative purposes only and do not in any way reflect the true economic viability of this operation.
Moreover a number of technical adjustments for the achieved results have been purposely left out to keep the exercise as simple as possible. These include, but are not limited to, associated tax implications, adjustments for residual income at the end of the five-year period, reflecting income generated beyond the planning period, among others.
Most financial institutions would require you to prepare a similar analysis of your venture in support of your claims of its viability before these can commit to some form of financing.
In most cases, these financial projects would need to be supported by a business plan that substantiates the claims and assumptions made in your financial results.
In the next article I shall provide an overview of what key elements should be included in your business plan, to develop an attractive proposition and convince investors to finance the initiative.
David Galea, B.Com (Hons), CPA, MBA (Warwick), is director of 4Sight Consulting Group, an entity involved in the provision of a wide range of professional services through a network of service providers.
Mr Galea, who recently successfully completed a Master's in Business Administration in conjunction with the University of Warwick, with distinction, has extensive management consulting experience in both the private and public sectors.
For more information, e-mail davgalea@maltanet.net or alternatively log on to www.4sight-consulting.com.