FINANCIAL ANALYSIS OF BENCHMARKING ALTERNATIVES

When comparing benchmarking alternatives, it is often necessary to take into consideration the fact that cash is received and/or disbursed in different time periods for each of the alternatives. Cash received in the future is not as valuable as cash received today because cash received today can be reinvested and earn a return. In order to compare the current value of cash received or disbursed in different periods, it is necessary to convert a future dollar value to its present value.

For example, the present value of $1100 received a year from now is $1000 if money can be invested at 10%. The alternative way to view this is to note that the future value of $1000 invested for one year at 10% is equal to 1000 times 1.10 or $1100.

The following table can be used to determine the present value of a future cash flow depending upon the discount rate and the number of years from the present that the investment is made. To relate to the discussion above, note that the Present Value Factor for one year at 10% is .9091. Therefore, the present value of $1100 received a year from now is $1000, i.e., $1100 times .9091.

A typical capital project of benchmark alternative evaluation is discussed in the following pages. The projected net income after tax as well as a summary of the investments made in the project, the after-tax salvage value, and the cash flow associated with the project are indicated.

The assumptions used to generate the net income are indicated below the projection. Note the separation of fixed and variable cost and the relationship between specific assumptions and the level of capacity utilization. In this case, the investment is assumed to occur at the end of the first year. Also, there is no increase in working capital associated with the construction of the plant.

The cash flow can be determined in one of two ways: (a) it is equal to the net income after tax plus depreciation or (b) it is equal to revenue minus operating expenses minus taxes. The net present value is indicated for several discount rates (10 to 40%). The net present value at 10% is determined, for example, as in Table 3.2.

Table 3.2: An Example of Cash Flow and Present Value

End of Year	Cash Flow	Present Value Factor	Present Value
1	-1,000,000	0.9091	-909,091
2	246,680	0.8264	203,868
3	597,764	0.7513	449,109
4	1,008,814	0.6830	689,034
		Total Net Present Value	432,919

Present Value Factors
	Discount Rate
Year	10%	20%	30%	40%
1	0.9091	0.8333	0.7692	0.7143
2	0.8264	0.6944	0.5917	0.5102
3	0.7513	0.5787	0.4552	0.3644
4	0.6830	0.4823	0.3501	0.2603
5	0.6209	0.4019	0.2693	0.1859
6	0.5645	0.3349	0.2072	0.1328
7	0.5132	0.2791	0.1594	0.0949
8	0.4665	0.2326	0.1226	0.0678
9	0.4241	0.1938	0.0943	0.0484
10	0.3822	0.1615	0.0725	0.0346

If the company cost of capital is 15%, then this project would be acceptable because the net present value is positive at that discount rate. A similar analysis can be used to determine a breakeven product price ” see Table 3.3.

Table 3.3: Benchmark Project Evaluations

	2001	2002	2003	2004
Sales (units)		21,000	49,000	66,500
Unit price		38.00	40.66	45.54
Revenue		798,000	1,992,340	3,028,357
Operating expense		420,200	1,029,400	1,397,000
Depreciation		50,000	50,000	50,000
Net income before tax		327,800	912,940	1,581,357
Tax		131,120	365,176	632,543
Net income after tax		196,680	547,764	948,814
Investment	1,000,000
Salvage value	10,000
Cash flow	-1,000,000	246,680	597,764	1,008,814
Interest rate (%)	10	20	30	40
Net present value	432,919	170,404	2,030	-107,982
Assumptions
Plant capacity (units)		70,000
Unit price ” start		38.00
Tax rate (%)		40
Depreciation (%)		5
Capacity utilization (%)		30	70	95
Price increase (%)		7	7	12

Operating Expense
Units	Fixed	Variable
10,000	200	20.00
20,000	200	20.00
30,000	200	20.00
40,000	400	21.00
50,000	400	21.00
60,000	500	21.00
70,000	500	21.00