You just got that dreaded call: your finance officer wants to talk to you about your project
- It costs money to raise the capital funds to pay for your project.
- If not for your project, those funds might have been earning profits on something else.
- Is, or was, your project a better opportunity?
- Did your project improve the financial position of your company?
In simple terms, here's what your finance officer is talking about:
- Perhaps the 'cost of capital' (CoC) for your project's funds was 6% of the money raised, for example (interest paid out on bonds sold for capital funds, or interest on loans, etc)
- And -- as dubious as it may be -- the finance officer can establish a firm cause-and-effect between increased business profit -- say 10% return on the money borrowed (ROI) or $1M by example -- and the success in the market of your project. (*)
- The EVA is then just a calculation: 'Increased profit' x (ROI - CoC)
In this case: $1M (10% - 6%) = $40K
Thanks for that! Your project actually improved cash flow and added to business financial success!
A better opportunity?
If there was another opportunity competing for the capital funds, then it would have to do better than return $40K on $1M raised the capital markets. The CoC might have been lower; or the ROI greater in order to best your project.
And the risk attendant with making $1M in profit would also be evaluated with discounted cash flow analysis. Maybe your project is given a more favorable discount rate.
The finance officer makes all those assessments as input to the decision process to fund your project or not.
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(*) I say dubious because cause-and-effect is notoriously difficult to prove, to wit: there may have been other business changes during your project's time frame that also influenced profit. How do you disentangle that?
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