Chapter 5: Feasibility Analysis

Overview

Part of the planning process used to evaluate current or long-range plans.  The chapter explains the methods of applying financial study techniques to determine which of several alternatives provides the best result. The purpose of Feasibility Analysis is to examine alternatives from both financial and technical perspectives. An effective process of studying feasibility eliminates alternatives by spending the least amount of effort.

Steps in Feasibility Analysis

1.      Begin with clear idea of objectives and knowledge of products (which can be obtained from vendors).
2.      Develop alternatives (1) From brainstorming sessions or 2) Input from experts, or even 3) Do nothing—status quo).
3.      Compare alternatives with objectives and look at advantages/disadvantages.
4.      Conduct financial evaluation/analysis.  Compare financial results.
5.      Sell the plan to higher management.  Remember--important to “speak the language” of business. Show financial or tangible benefits as well as intangible—such as improved productivity. Foresee objections and address them directly.  Discuss all alternatives and be concise or focus on major points and lead to conclusions. Include an executive summary as well as all needed details in report and any needed backup material in appendix.

Financial Evaluation Techniques

Payback Period:  (Least valid, capital investment divided by annual savings to determine how many years it will take to “payback.” Problem:  ignores time-value of money).

Present Value:  (Move all expenses and revenues to present time by discounting them to present value.  Think of it as the money you would have to invest now to pay bill when it comes due). 

Net Present Value:  (The sum of the discounted cash flows, minus the original investment, and used to compare two alternative investments). Tells what alternative is most cost-effective.   Most NPV’s in telecommunications are negative—because they are a cost).

Internal Rate of Return:  (Shows the amount of money the investment returns.  Determined by finding discount rate at which NPVs of two alternatives are equal).  Not always a valid indicator and is time consuming if done by hand.  Most spreadsheet programs have an IRR function.

Feasibility Study Process Steps for NPV

1.      Determine cost factors for each alternative.
2.      Assign values to the factors, (which can be obtained from vendor quotes, organization’s costs factors, etc.).
3.      Determine organization’s cost of money from accounting/finance department.
4.      Discount cash flow to present value.
5.      Add the present values and subtract initial investment---to obtain NPV.

By calculating the difference between the NPV’s of the alternatives, you can rank products by what they will cost over their service life.

Other Considerations

Study Length:  (An important factor in determining which product is most economically attractive.  The longer the assumed project life, the greater the chance a high cost alternative has to demonstrate economic efficiency—through lower recurring costs).

Cost of Money:  (Is the composite cost of capital, which is the weighted average cost of equity, debt and retained earnings).

Inflationary Expectations:  (In an inflating economy, costs—wages, etc. increase with time, so a capital investment in labor saving equipment offsets future recurring costs.  The higher the expected inflation, the more effective the capital investment becomes if it decreases expense).

Tax Considerations:  (Capital investment reduces income taxes:  1) Deduction of depreciation; 2) Deduction of annual expenses).

Use of Computers in Calculations:  (Calculations done manually are tedious.  Most spreadsheet programs include NPV and IRR functions—so there is no need to look up discount factors, etc., and you can calculate a stream of cash flows without the need to look up compounding factors).

Other Considerations:  (It may be impossible to quantify some factors into a cost study—security, instability/uncertainty over changing technologies, management attitudes regarding risk, company stability, etc.).

Conducting Analysis

Conducted by estimating the cash flow for each factor from beginning of the life of the project to end. This can be done manually, but use of a computer is recommended.

The outcome yields financial indicators to predict the economic performance of products.  (NPV and IRR are generally most important).

Interpreting Results

NPV is the most significant indicator of feasibility of an alternative. (Product with highest NPV will take least cash from organization).

If alternatives increase revenue (produce revenue) NPV may be positive. (In many telecom projects, revenues are equal for all alternatives and are therefore omitted from study.  In this case, NPV is minus/negative and the most effective product has the least negative NPV).

Remember, telephone systems play a supportive role to business and generally do not produce revenue, therefore it is a “cost of business” and most cash flows will be negative.

IRR is an indicator of how efficiently the capital is used in a business and if it is not at least as high as the cost of money, the product consumes capital.  (The amount of capital required is important, particularly if organization has a shortage).

Handle uncertainty with objectivity.  Best way to deal with it is to rerun analysis with a range of values—or do a sensitivity analysis, which will allow you to determine which assumptions have the greatest effect on the outcome.  Sensitivity analysis allows for results to be tested to different assumptions.

Case Study Example: (Page 86).

The chapter also provided a case study example of a feasibility study conducted by a company who was in the process of constructing a new office and looking at whether or not they should keep or replace their existing PBX system.  The alternatives were:  1) Move the existing PBX, 2) Replace the existing PBX with a new model, or 3) Use a digital “Centrex” from the LEC. The study determined that it was better to go with the new PBX system over the Centrex system.
·        The new PBX system had a large initial cost and lower recurring costs.
·        The Centrex had a lower initial cost but larger recurring costs.