Owners and managers face many tough questions in the normal course of operating a business. Should I expand into new product lines or geographic markets? Can I afford to buy a cutting-edge piece of equipment? Does it make sense to build this component in-house or to outsource its production? Which investment alternative will give me the greatest return?

For most day-to-day decisions, managers only have time to make rapid choices based on experience and acumen. But as the dollars at stake grow to tens or hundreds of thousands, so will sleepless nights if managers base strategic decisions solely on those factors. For big-ticket items — and greater peace of mind — managers often turn to feasibility studies.

Case in point
To illustrate how feasibility studies can facilitate management’s decision-making process, consider the fictitious example of Dom’s Tool & Die Co. Dom’s operations manager recently suggested that his tool-and-die shop could win several large jobs from a nearby competitor if the company purchased a $1 million state-of-the-art piece of machinery.

Initially, Dom was skeptical. Although the purchase made sense from a selling and operations perspective, Dom and his overworked controller, Louise, lacked the time and knowledge needed to fully evaluate this decision from a financial perspective.

After discussing the prospective investment with his company’s attorney, Dom decided to hire Bob, a valuation professional, to help him crunch the numbers. Bob created a detailed spreadsheet that coordinated information gathered from the company’s sales, operations and accounting departments.

One of the features of Bob’s spreadsheet that most appealed to Dom was its flexibility. He could modify one cell — let’s say increase the company’s cost of capital from 18% to 20% — and instantly see how the change affected the rest of the spreadsheet.

In arriving at his conclusions, Bob assumed an eight-year useful life, a $25,000 salvage value and a constant $250,000 increase in annual cash flows from the new machine.

Most important, Bob summarized his findings with three easy-to-understand metrics. These allowed Dom and his management team to effortlessly evaluate the potential purchase’s key components: payback period, net present value and internal rate of return.

In this case, it will take Dom’s Tool & Die four years to recoup its initial investment from the equipment’s incremental cash flows. Though some managers rely exclusively on the payback period to gauge an investment’s viability, the payback period alone doesn’t consider differences among the useful lives of multiple investment alternatives or the time value of money.

The slightly more complex net present value (NPV) and internal rate of return (IRR) aim to remedy any payback-period shortcomings. NPV provides a summation of an investment’s cash inflows and outflows at a specific discount rate.

Bob estimated the tool-and-die shop’s cost of capital at 18% and arrived at an NPV of approximately $26,000. To the extent that an investment’s NPV is greater than zero, the investment makes sense.

Finally, IRR estimates an investment’s yield over its useful life. It is also the point at which the investment’s NPV is zero. In evaluating this metric, many managers will compare it to a subjective “hurdle rate,” which is the minimum rate of return management requires before it will accept a project. Frequently, management uses a company’s cost of capital as the hurdle rate that a project must clear for acceptance. If the IRR is greater than management’s predetermined hurdle rate, the investment makes sense.

Back to our example. Dom was initially disappointed at the machine’s lengthy projected payback period. When he questioned Bob about it, the valuation professional brought up some of the less obvious benefits of the strategic purchase that Dom hadn’t previously considered.

When Dom and his management team finally decided to purchase the new machine, they were confident that they had evaluated all of the relevant information and that their choice was the right one.

Drawing conclusions
While large public companies may have the staff and resources needed to perform complex feasibility analyses, small to midsize businesses often turn to outsiders for assistance. Professional valuators are perfectly suited to handle these types of consulting engagements.

Unlike many traditional accountants who focus solely on the latest accounting standards rulings and IRS codes, valuators are more comfortable with discounted cash flow techniques, as well as how to construct malleable, interactive spreadsheets that answer their clients’ tough questions en route to educated choices.