From a Corporate Finance and Governance perspective, the IMP is about answering three fundamental questions:
1. How much value does the organisation create/destroy today?
2. What are the options (investment decisions) available to management to increase the future value created by the organisation?
3. What are the key priorities (actions) which should be recommended to management?
To answer all three questions appropriately, you need to refer to an analytical framework, a tool enabling you to:
1. Define the concept of Value;
2. Identify the key Value Drivers;
3. Calculate them based on the information disclosed in the organisations' financial statements (position today);
4. Project them into the future, making sound and justified assumptions about operational improvements or new opportunities for investment (position in the future);
5. Rank them in order of contribution to future value creation for the organisation (recommendations to management)
6. Identify any relevant governance issues related to your evaluation. As we discussed during the CFG module, an organisation (or a project) creates value when it generates positive (higher than 0) cumulative free cash flows, discounted at a rate (the cost of capital) appropriate for the organisation/project. The tool that will help you in identifying the determinants of future free cash flows is the Strategic Value Analysis (SVA) framework. To determine the current financial position of an organisation or a business unit, you will need to derive its Value Drivers from the financial statements or from the information available to you. If you are dealing with a project, the starting point will be the initial investment needed to generate future incremental free cash flows. Then you will need to calculate the discount rate, the weighted average cost of capital (WACC), to bring the future free cash flows back to present values.
Sometimes it can be particularly hard to find all the relevant information: do not be afraid to make assumptions, just remember to state them. If the financial information available to you is too limited... well, look at another organisation or project. You need to be familiar with the organisation or project, but this does not imply that it is your organisation or your project. Once again, remember to state your perspective of analysis as an employee, a consultant or an analyst.
- Cash Taxes
= Operating cash flows
- RFCI: Replacement Fixed Capital Investment
- IFCI: Incremental Fixed Capital Investment
- IWCI: Incremental Working Capital investment
= Free Cash Flows to the Firm
Estimating free cash flows: the Value Drivers.
CASH PROFIT GENERATION
INCREMENTAL CASH NEEDED
Once you have defined the starting point of your analysis, you need to stretch the Value Drivers into the future (3-5 years or longer, if necessary). By changing the relevant Value Drivers according to the strategic direction of the organisation and the influence of the global business environment, you will be able to model the impact of managerial options on the net present of future cumulative cash flows. This process can be applied to the entire range of managerial investment decisions, from operational improvements to new incremental projects (including mergers, acquisitions and divestitures).
The Value created will result from the incremental free cash flow generated by each single option valuated, compared to a base case scenario (status quo). A basic sensitivity analysis will help you to quantify the role of uncertainty on future investment decisions. This should be underpinned by a discussion of and reasons for making assumptions in your evaluation. Your recommendations to management will be consistent to the quantitative outcomes of your SVA analysis.