Matt Jackson, Strategic Consulting, Jones Lang LaSalle and Matt Highfield, Senior Vice President, Strategic Consulting, Jones Lang LaSalle (Winter 2011)
3. Operating Expenses
Operating expense inputs consist of costs for start-up expenses, indirect labor, indirect tax, depreciation, and other selling, general, and administrative costs. Operating expense costs are generally lower than COGS cost inputs, except for depreciation. Like COGS inputs, most operating expense inputs are geographically variable, and the method of calculation can change radically locally and nationally. Sales tax (or value added tax) and its treatment in the model presents another key concern. When modeling, it is necessary to determine if the company will show the tax impact, often in excess of 15 percent, in its financial view of the project (effectively reducing the margin on revenue) or whether the customer will incur the tax.
4. Direct Tax
Typically, the formula for calculating taxable income is taxable earnings less loss carried forward, multiplied by the applicable income tax rate (standard or preferential). Since many countries utilize income tax as an incentive, income tax liability can vary significantly between countries. This is a critical consideration for industries with products that have high gross margins, which translates to more taxable income. Income tax rates in many countries often exceed 25 percent, but some countries offer three-, five-, 10-, and possibly 20-year exemptions or reductions from income tax.
5. Other Factors
In addition to revenue, COGS, operating expenses, and direct tax, external market factors influence longer-term financial merits of direct investment, such as inflation, currency exchange rates, and incentives. Inflation directly affects operating costs and will increase the cost denominator driving most financial calculations over the analysis period.
Currency exchange policy falls within exchange rates tied to the U.S. dollar and highly volatile free market rates. Businesses can hedge exchange rates, although they are difficult to predict.
Companies cannot control incentives policies as easily, however, which can notably affect project economics. Federal, state, and local governments can often extend incentives to attract direct investment, thereby making a location more financially desirable. Programs that reduce one-time costs (connection fees, import duty exemptions, infrastructure subsidies, land prices, recruiting and training) and recurring costs (utility rate tariffs, tax reductions) are all common.
Measuring Output and Performance
The model would ideally include output for key metrics to lend insight into the investment decision, including free cash flow (FCF), cumulative net present value (NPV), and return on invested capital (ROIC). Free cash flow is a measure of financial performance that provides visibility and allows a company to know exactly when a project generates a positive return. Cumulative NPV enables an understanding of how much the project will add - or detract - to the enterprise. Return on invested capital is the percent amount earned on the total invested capital, or how effectively the company has used the invested money. A model will often include other key, company-specific performance metrics such as cost per unit of output.
Modeling emerging markets is complex and requires significant time and resources to achieve accuracy. If the activity is not well coordinated and model inputs are poorly calibrated, there is a higher risk for misleading results. Ensuring accuracy begins with developing a tight set of project specifications and assumptions. The model architecture must then be able to capture a wide range of highly variable and interrelated data inputs. If a company fails to develop a comprehensive view of the investment, it will be impossible to develop appropriate outputs to measure the investment's merits.