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E l ti f I t t P j t Evaluation of Investment Project
kszczepaniak@wzr.pl
Ph.D. Krzysztof Ph.D. Krzysztof Szczepaniak Szczepaniak
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. . ys o . . ys o c ep c ep
AGENDA
1. Types, phases and stages of investment: Definition and classification of
investment projects, Main stages of formulation of an investment project,
G l t i th l i f i t t j t General steps in the analysis of investment project
2. Parameters in the basic financial and economic analysis of investment:
enumeration, characterization, main expenditures and cost of investment
3. Time value of money: Present Value PV, Future Value FV, Compound
interest, Discounting rate
4. Investment project life cycle
5. Main elements the feasibility study of investment project
6 Project financing: Structure of capital Cost of capital Weighted Average 6. Project financing: Structure of capital, Cost of capital, Weighted Average
Cost of Capital discount rate
7. Financial analysis and investment appraisal: Free Cash Flow for Firm,
Free Cash Flow to Equity, Criteria for evaluation and selection of
investment projects, Assessment at current prices and constant prices
8. Methods of projects profitability appraisal
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Test 20-30 / project
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Investment
The stream of cash flows which are beginning with cash
outflows, but the investor expects for much higher cash p g
inflows in the future
The capital expenditures made by an investor who requires
much higher income in the future
An asset or item that is purchased with the hope that it
will generate income or appreciate in the future.
In an economic sense, an investment is the purchase of
d th t t d t d b t d i th
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goods that are not consumed today but are used in the
future to create wealth.
In finance, an investment is a monetary asset purchased
with the idea that the asset will provide income in the future
or appreciate and be sold at a higher price.
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Investment project
The concrete form of idea that can help to
transform the capital of investors into working transform the capital of investors into working
property (assets)
The complex plan of an investor activities
Main goal of investor is to build, buy or
renovate the property of company
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Investment project (2)
Any decision that requires the use of resources (financial or
other) is a project.
Broad strategic decisions
Entering new areas of business
Entering new markets
Acquiring other companies
Tactical decisions
Management decisions
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The product mix to carry
The level of inventory and credit terms
Decisions on delivering a needed service
Lease or buy a distribution system
Creating and delivering a management information system
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Investment objective
Important questions:
Current liquidity and net worth Current liquidity and net worth
Risk aversion
Investment time horizon
Capital expenditure level
Income levels
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Expense levels
Restrictions on security selection
Companies:
To stay forever on the market
What is risk?
Risk, in traditional terms, is viewed as a
negative factor negative factor.
Risk is a mix of danger and opportunity
The risk on any individual investment can be
broken down into two sources. Some of the
risk is specific to the firm, and is called firm-
specific whereas the rest of the risk is specific, whereas the rest of the risk is
market- wide and affects all investments.
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Risk types
The risk faced by a firm can be fall into the following categories
1) Project-specific; an individual project may have higher or lower ) j p ; p j y g
cash flows than expected.
2) Competitive Risk, which is that the earnings and cash flows on
a project can be affected by the actions of competitors.
3) Industry-specific Risk, which covers factors that primarily
impact the earnings and cash flows of a specific industry.
4) International Risk, arising from having some cash flows in
currencies other than the one in which the earnings are currencies other than the one in which the earnings are
measured and stock is priced
5) Market risk, which reflects the effect on earnings and cash
flows of macro economic factors that essentially affect all
companies
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The Effects of Diversification
Firm-specific risk can be reduced, if not eliminated, by increasing the
number of investments in your portfolio (i.e., by being diversified).
Market-wide risk cannot. This can be justified on either economic or
statistical grounds.
On economic grounds, diversifying and holding a larger portfolio
eliminates firm-specific risk for two reasons:
each investment is a much smaller percentage of the portfolio,
muting the effect (positive or negative) on the overall portfolio,
firm-specific actions can be either positive or negative; in a large firm specific actions can be either positive or negative; in a large
portfolio, it is argued, these effects will average out to zero. (For
every firm, where something bad happens, there will be some
other firm, where something good happens.)
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Risk Tolerance
The degree of uncertainty that an investor
can handle in regard to a negative change in can handle in regard to a negative change in
the value of his portfolio
Example:
An investor's risk tolerance varies according to
age, income requirements, financial goals, etc.
For example, a 70-year-old retired widow will
generally have a lower risk tolerance than a
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generally have a lower risk tolerance than a
single 30-year-old executive, who generally
has a longer time frame to make up for any
losses she may incur on her portfolio
Thegoalsof investing
to increase income of the owner of company
t i th l f th to increase the value of the company
The Value of Company discounted free cash
flow
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!!! Not only the Net Income (after taxes) is
important
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Measuring Returns Correctly
Use cash flows rather than earnings. You cannot
spend earnings. spend earnings.
Use incremental cash flows relating to the
investment decision, i.e., cash flows that occur as a
consequence of the decision, rather than total cash
flows.
Use time weighted returns, i.e., value cash flows
that occur earlier more than cash flows that occur that occur earlier more than cash flows that occur
later.

The Return Mantra: Time-weighted, Incremental

Cash Flow Return

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Objectivesof Investment Management
Neither
M i i i f N t I di t Maximizing of Net Income according to
known Capital Expenditures and acceptable
risk
Nor
Getting specific Net Income at minimal
C it l E dit
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Capital Expenditures
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What is important?
Invest in projects that yield a return greater than the minimum
acceptable hurdle rate.
The hurdle rate should be higher for riskier projects and reflect the
financing mix used - owners funds (equity) or borrowed money
(debt)
Returns on projects should be measured based on cash flows
generated and the timing of these cash flows; they should also
consider both positive and negative side effects of these projects.
Choose a financing mix that minimizes the hurdle rate and
matches the assets being financed matches the assets being financed.
If there are not enough investments that earn the hurdle rate,
return the cash to stockholders.
The form of returns - dividends and stock buybacks - will depend
upon the stockholders characteristics.
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Types of Investments
INVESTMENT
Alternative
Financial Capital Intangible
- Bonds
- Shares
C i
Companies:
- new buildings;
developingexisting
- Research& Development;
- licenses;
trademarks;
Alternative
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-Currencies
-Real estate
- developing existing
assets;
-Renovation
-Real estate
- trade marks;
- upgradingof staffs
knowledge;
- promotionand marketing.
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Capital Expenditure - CAPEX
Funds used by a company to acquire or
upgrade physical assets such as: upgrade physical assets such as:
property,
industrial buildings
or equipment.
This type of outlay is made by companies
t i t i i th f th i
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to maintain or increase the scope of their
operations.
Depreciation
In accounting, an expense recorded to
allocate a tangible asset's cost over its useful allocate a tangible asset s cost over its useful
life.
Depreciation increases free cash flow
because it is a non-cash expense
It increases free cash flow while decreasing
reported earnings
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reported earnings
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Amortization
The deduction of capital expenses over a
specific period of time (usually over the specific period of time (usually over the
asset's life).
More specifically, this method measures the
consumption of the value of intangible
assets, such as a patent or a copyright,
brands intellectual property
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brands, intellectual property
Discounted Cash Flow (DCF)
A key valuation tool at analysts' disposal is
discounted cash flow (DCF) analysis. Analysts use ( ) y y
DCF to determine a company's current value
according to its estimated future cash flows.
Forecasted free cash flows (operating profit +
depreciation + amortization - capital expenditures -
cash taxes - change in working capital) are
discounted to a present value using the company's
weighted average costs of capital
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weighted average costs of capital.
For investors keen on gaining insights on what drives
share value, few tools can rival DCF analysis.
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FCF is also calculated as
+ Net Income
D i ti /A ti ti + Depreciation/Amortization
- Changes in Net Working Capital
- Capital Expenditures
= Free Cash Flow
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Free Cash Flow For The Firm - FCFF
A measure of financial performance calculated as
operating cash flow minus capital expenditures. Free p g p p
cash flow (FCF) represents the cash that a company
is able to generate after laying out the money
required to maintain or expand its asset base.
Free cash flow is important because it allows a
company to pursue opportunities that enhance
shareholder value. Without cash, it's tough to develop
new products make acquisitions pay dividends and
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new products, make acquisitions, pay dividends and
reduce debt.
FCFF = Operating Cash Flow Expenses Taxes
Changes in NWC Changes in Investment
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FreeCash Flowto Firm (FCFF)
Revenues from the sale
- operating variable costs
- operating fixed costs without the amortization and depretiation
- amortization and depretiation as a cost
= operating profit before interest and tax (EBIT)
- the income tax counted up from the profit EBIT
= operating profit after tax (NOPAT)
+ amortization and depretiation
- investment expenditures on fixed assets funded both the own capital and
borrowed capitals
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- the changes of working capital (CWC)
= free cash flow to firm (FCFF)
FreeCash Flowto Equity (FCFE)
Revenues from the sale
- operating variable costs
i fi d i h h i i d d i i - operating fixed costs without the amortization and depretiation
- amortization and depretiation as a cost
= operating profit before interest and tax (EBIT)
- interest paid from loans
= gross profit (to taxation)
- income tax
= net profit (after taxation)
+ amortization
- investment expenditures on fixed assets funded only by own capital
- loan repayments (only the principal amunt)
- the changes of working capital (CWC)
__________________________________________________________
= free cash flow to equity (FCFE)
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Standard approach Equity approach
Net income Net income
Comparisonof twoformulations
Net income Net income
+Amortization +Amortization
+Interest*(1-T) - CWC
-CWC -CAPEX
-CAPEX -(Principal amount
repayment new
loans)
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)

FCFF FCFE

Discount rate WACC with
the tax shield
Dicount rate the
investeors expected rate of
return
Working Capital
A measure of both a company's efficiency and its
short-term financial health. The working capital ratio
i l l t d is calculated as:
Working Capital = Current Assets Current Liabilities
Positive working capital means that the company is
able to pay off its short-term liabilities.
Negative working capital means that a company
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Negative working capital means that a company
currently is unable to meet its short-term liabilities
with its current assets (cash, accounts receivable
and inventory).
Also known as "net working capital", or the "working
capital ratio".
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Working capital positive or negative
Assets Liabilities
Property
Assets Liabilities
Property,
equipment
Current assets
WC
(+)
Intangible assets
other investments
Shareholder's
Equity
Long-term debt
Propety,
equipment
Long-term debt
WC
( )
Intangible assets,
other investments
Shareholder's
Equity
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Current liabilities
(-)
Current assets
Current liabilities
Working capital positive

Working capital negative

Time Value of Money (TVM)

The idea that money available at the present time is
worth more than the same amount in the future, due worth more than the same amount in the future, due
to its potential earning capacity.
This core principle of finance holds that, provided
money can earn interest, any amount of money is
worth more the sooner it is received. Also referred to
as "present discounted value".
The time value of money: investors have alternative
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The time value of money: investors have alternative
uses for their funds and they therefore have an
opportunity cost if money is invested in a corporate
project
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Time Value of Money (2)
The investors opportunity cost: the sacrifice of the
return available on the best forgone alternative g
Investments must generate at least enough cash for
all investors to obtain their required returns. If they
produce less than the investors opportunity cost then
the wealth of shareholders will decline
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Time Value of Money (3)
Compensation is required to induce people to make a
consumption sacrifice p
Compensation will be required for at least three
things:
1. Time
Impatience to consume
Pure rate of interest
2. Inflation
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2. Inflation
3. Risk
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Investment appraisal: objective,
inputs and process
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Present Value(PV)
Current value of a future cash flow
PV
FV
Interest compounding
Cash flow discounting
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Present Value PV
The current worth of a future sum of money or stream
of cash flows given a specified rate of return. of cash flows given a specified rate of return.
Future cash flows are discounted at the discount rate,
and the higher the discount rate, the lower the
present value of the future cash flows.
Determining the appropriate discount rate is the key
to properly valuing future cash flows, whether they be
earnings or obligations
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earnings or obligations.
Also known as "discounted value".
Present Value
The basis is that receiving $1,000 now is worth
more than $1 000 five years from now more than $1,000 five years from now,
because if you got the money now, you could
invest it and receive an additional return over
the five years.
The calculation of discounted or present value
i t l i t t i fi i l
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is extremely important in many financial
calculations. For example, net present value,
bond yields, spot rates, and pension
obligations all rely on the principle of
discounted or present value.
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Future Value FV
The value of an asset or cash at a specified date in
the future that is equivalent in value to a specified the future that is equivalent in value to a specified
sum today. There are two ways to calculate FV:
1) For an asset with simple annual interest: = Original
Investment x (1+(interest rate*number of years))
2) For an asset with interest compounded annually: =
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Original Investment x ((1+interest rate)^number of
years)
Future (FV) / Present Value (PV) (1)
Simple (stright) annual interest: Simple (stright) annual interest:
...) 1 (
) 1 (
2 2 1 1
+ + + =
+ =
n r n r PV FV
n r PV FV
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FV future value
PV present value
r interest rate per year
n number of years
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Compound interest Compound interest
Future (FV) / Present Value (PV) (2)
( ) ) 1 ( ) 1 (
) 1 (
2 2 1 1
2 1
+ =

m n m n
m n
r r
PV FV
m
r
PV FV
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(...) ) 1 ( ) 1 (
2 2 1 1
2
2
1
1
+ + =
m n m n
m m
PV FV
r interestrateper year
n number of years
m number of periods in one year over which compounding takes place
Compound interest
The ability of an asset to generate earnings, which
are then reinvested in order to generate their own are then reinvested in order to generate their own
earnings. In other words, compounding refers to
generating earnings from previous earnings.
Interest that accrues on the initial principal and the
accumulated interest of a principal deposit, loan or
debt
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debt.
Compounding of interest allows a principal amount to
grow at a faster rate than simple interest, which is
calculated as a percentage of only the principal
amount.
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1) $1000 invested for 5 years with simple annual interest
of 10% would have a future value of $1,500.00
Consider the following examples (FV)
of 10% would have a future value of $1,500.00
2) $1000 invested for 5 years at 10%, compounded
annually has a future value of $1,610.51
) 5 10 , 0 1 ( 1000 + = FV
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1 5
) 10 , 0 1 ( 1000

+ = FV
Discount rate
The interest rate used in determining the present value of
future cash flows.
For example:
Let's say you expect $1,000 dollars in one year's time. To
determine the present value of this $1,000 (what it is
worth to you today) you would need to discount it by a
particular rate of interest (often the risk-free rate but not
always). Assuming a discount rate of 10%, the $1,000 in
a year's time would be the equivalent of $909 09 to
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a year's time would be the equivalent of $909.09 to
you today
45 . 826
) 10 , 0 1 (
1
1000
2
2
=
+
= PV 09 . 909
) 10 , 0 1 (
1
1000
1
1
=
+
= PV
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Effective Annual Rate (r
e
)
An investment's annual rate of interest when
compounding occurs more often than once a compounding occurs more often than once a
year. Calculated as the following:
1 ) 1 ( + =
m
n
e
m
r
r
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r
n
nominal interest rate
m number of compounding investment in
one year
Risk-free return (RFR)
Mrs Ann Investor
Considering a 1 000 one-year investment and requires Considering a 1,000 one year investment and requires
compensation for three elements of time
1. A return of 4 per cent is required for the pure time value
2. Inflation 10 per cent over the year
3. To compensate the investor for impatience to consume and
inflation the investment needs to generate a return of 14.4
per cent, that is: (1 + 0.04) (1 + 0.1) 1 = 0.144
Th fi f 14 4 t i th i k f t (RFR) The figure of 14.4 per cent is the risk-free return (RFR)
Required return = RFR + Risk premium
(Time value of money)
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Inflation
Rate at which proces as a whole are increasing
Nominal Interest Rate Rate at which money
invested grows.
Real Interest Rate Rate at which the
purchasing power of an investment increases purchasing power of an investment increases
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Inflation
1+ i l i t t t
1+ real interest rate =
1+nominal interest rate
1+inflation rate
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Example:
If the interest rate on one year government
bonds is 6 5% and the inflation rate is 2 5% bonds is 6,5% and the inflation rate is 2,5%,
what is the real interest rate?
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Example:
If the interest rate on one year government
bonds is 6 5% and the inflation rate is bonds is 6,5% and the inflation rate is
2,5%, what is the real interest rate?
1+ real interest rate = (1+0,065)/(1+0,025)=
= 1,039
Real interest rate is 3,9%
It is not 4,0% !!!
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C i l
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Capital structure
Capital structure typesof capital
/b d own/borrowed
Short-/longterm
Outside/inside
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Rate of return on shares (1):
cE= cB + RP
cE= cost of equity capital
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cB= cost of bonds
RP = risk premium
Rate of return on shares (2):
CAPM Capital Asset Pricing Model CAPM Capital Asset Pricing Model
c
E
= r
f
+ (r
M
r
f
)
R
f
- The expected risk-free return in that market (government bond yield)
r
M
- The historical return of the stock market/ equity market
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r
M
The historical return of the stock market/ equity market
-The sensitivity to market risk for the security
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Rate of return on shares (2):
The capital asset pricing model
(CAPM) i d i fi t (CAPM) is used in finance to
determine a theoretically appropriate
price of an asset such as a security.
The market risk is normally
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characterized by the parameter.
Rate of return on shares (3)
Gordon Model
The most influential model for calculating the cost
of equity of equity.
The rate of return investors require on a share
is equal to the prospective dividend yield plus
the rate at which the dividend stream is
expected to grow
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expected to grow.
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Rate of return on shares (4):
Gordon Model
Do dividend per share in the previous year
( )
g
P
g D
g
P
D
c
E
+
+
= + =
1
0 1
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Do dividend per share in the previous year
D1 dividend per share in the current year
P market price
g the level of dividend increasing per year (in percent)
Preference Share Capital
Preference shares have some characteristics in Preference shares have some characteristics in
common with debt capital (e.g. specified annual
payout of higher ranking than ordinary share
dividends) and some characteristics in common with
equity (dividends maybe missed in some
circumstances and the dividend is not tax deductible).
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Cost of Preference Shares:
D
D dividend per share
P
D
c
P
=
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P market price of share
Cost of Debt Capital
It is determined by the following factors: y g
The prevailing interest rates
The risk of default
The benefit derived from interest being tax
deductible
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Cost of Bank Loan
cL= cn*(1 T )
cL cost of bank loan
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cn nominal cost of bank loan
T corporate tax rate
Cost of Corporate Bonds(c
B
)
( )
I
| |
m
I the value of interest of bond (over one year)
V adjusted value of bond
( ) T
V
I
c
O
B
= 1
|
.
|

\
|
= r
m
P V
O
12
1
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V
O
adjusted value of bond
P market price of bond
m the number of months since the last paid interest
r interest rate of bonds
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WACC Weighted Average Cost
of Capital
The firms need to offer returns to
finance providers commensurate finance providers commensurate
with the risk they are undertaking.
The amount of return is determined by
what those investors could get
elsewhere at the risk level (e g by
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elsewhere at the risk level (e.g. by
investing in other companies).
WACC Weighted Average Cost
of Capital
I l l t d b i hti th t f d bt d Is calculated by weighting the cost of debt and
equity in proportion to their contributions to
the total capital of the firm.
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Weighted Average Cost of Capital -
WACC
A calculation of a firm's cost of capital in which each
category of capital is proportionately weighted. All category of capital is proportionately weighted. All
capital sources - common stock, preferred stock, bonds
and any other long-term debt - are included in a WACC
calculation.
WACC is hard to calculate, but a solid way to
i t t lit
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measure investment quality
WACC simply formula
( )
C d d e e
T r s r s WACC + = 1 ( )
C d d e e
r
e
= cost of equity
r
d
= cost of debt
s
e
= E/V = share of equity in source of financing
s
d
= D/V = share of debt in source of financing
V = E + D
E = market value of the firm's equity
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E = market value of the firms equity
D = market value of the firm's debt
T
C
= corporate tax rate
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WACC general formula

=
n
c w WACC
w weight of capital
c cost of capital

=
=
i
i i
c w WACC
1
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i number of source of financing
WACC-example
Imagine that a corporation is to be
established by obtaining one-half of its established by obtaining one half of its
1.000 million of capital from lenders, who
require an 8% rate of return and one-half
from shareholders, who require a 12% rate
of return.
We need to calculate WACC to establish the
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We need to calculate WACC to establish the
minimum return needed on an investment
within the firm, that will produce enough to
satisfy the lenders and shareholders.
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WACC-example
Cost of debt kD=8%
C t f it k 12% Cost of equity kE=12%
Weight of debt (VD/(VE+VD) wD=0,5
Weight of equity (VE/(VE+VD) wE=0,5
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WACC=8%*0,5+12%*0,5 = 10%
WACC - exercises
1. The equity of GAMA Company includes 600 000
shares. The market price of one share is 24PLN. p
Last year, the company paid total dividend in
amount of 2 400 000PLN. The company estimates
that the dividend will increase 5% per year. What is
the cost of equity capital in this company?
2. What is the cost of shares in company WEGA if the
market price is 39 6PLN? The company paid
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market price is 39,6PLN? The company paid
dividends last year it was 6PLN per share. The
company estimates, that it will reinvest 70% of net
profits and will reach 8% return of equity.
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3. What is the cost of bonds, which nominal
value is 175PLN? The interest rate of those value is 175PLN? The interest rate of those
bonds is 6% per year, the market price is
180PLN and the interest were paid last time
6 months ago.
4. What is the cost of bonds, if we know that
the interest rate is 7 4% and the nominal
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the interest rate is 7,4% and the nominal
price of bond is 55PLN? Those bond are
worth today 8% more than the nominal
value. The interest were paid last time 6
months ago.
WACC - exercise
5. The capital of company WIST includes:
2000 of preference shares with nominal price of 000 o p e e e ce s a es t o a p ce o
28PLN and market price of 30PLN per share.
The owners of those shares reach dividends
6,6PLN per share;
8250 of shares with nominal price of 15PLN and
market price 20PLN per share. The dividend per
share was 4z last year and managers expect it
will increase 2,5% per year;
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will increase 2,5% per year;
bank loan interest rate is 12% per year, loan
value - 75 000 z; T = 19%
Make calculation of WACC.
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The investment decision:
alternative uses of firms funds
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FEASIBILITY STUDY OF
INVESTMENT
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Feasibility study - contents
The feasibility study is prepared to The feasibility study is prepared to
apprise the profitability of investment
project
You do this to help the investor in making
right decision about investing his money
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Feasibility study contents (2)
I. Executive summary
II. Project concept and history II. Project concept and history
III. Market analysis and marketing concept
IV.Raw materials and supplies
V. Location, site and environment
VI.Engineering and technology
VII.Organization and overhead costs
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VIII.Human resources
IX.Implementation planning and budgeting
X. Financial analysis and investment appraisal
XI.Economic cost-benefit analysis
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Basic aspects of investment studies
Strategic orientation
What is right investment? g
Project concept
Market
Socio-economic and natural environment
Basic strategic principles
Concentration of forces
Risk balance
Cooperation
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Cooperation
Scope of project
Data requirements and terminology
Justification of alternatives and assumptions
Reliability of costs estimates
Cost of investment studies
Strategy development within the
framework of investment studies (1)
1. Formulation of general project objectives
- project concept, socio-economic environment and project concept, socio economic environment and
history of project
- project vision
- strategic principles
2. Determination of specific project objectives
- products
- markets
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- markets
- growth rates
- risks
3. Choice of project and company strategy
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Strategy development within the
framework of investment studies (2)
4. Determination of functional objectives and strategies
- Marketing: objectives, strategies and realization
- Material inputs and supplies: objectives and strategies
- Location, natural environment and site: objectives and strategies
- Production, technology and research and development:
objectives and strategies
- Financing: objectives and strategies
- Personnel, management and social security:
objectives and strategies
75
5. Development of right mix of functional objectives and
strategies
6. Planning of implementation of strategies
- Planning and optimal combination of resources
7. Checking and adaptation of strategies during construction
and operation of project
Project life cycle
All investment project life cycle could be divided into
three phases:
1. 1. Pre Pre--investment phase investment phase the preparing of the project
feasibility and other preparatory investigations, then
collecting equity and receiving of the loan from bank
2. 2. Investment phase Investment phase construction of new building,
acquisition and installation of the equipment,
trainings for workers, buying of the stock for the
start of production, experimental manufacture, the
beginning of manufacture using all potential of the
76
beginning of manufacture using all potential of the
technology and equipment
3. 3. Operating phase Operating phase manufacturing and selling all
kind of production using all potential of the
technology and equipment (usually until main
technology used in the project could be too old, or
the project would need bigger innovations)
2014-01-09
39
Preparation
FEASIBILITY STUDY
Pre-selection
PRE-FEASIBILITY STUDY
Identification
A i l
SUPPORT STUDIES
Engineering design
Negotiations and
contracting
Expansion
Innovation
Replacement
Rehabilitation
PRE PRE- -INVESTMENT INVESTMENT
PHASE PHASE
INVESTMENT INVESTMENT
PHASE PHASE
OPERATING OPERATING
PHASE PHASE
Identification
OPPORTUNITY STUDY
Appraisal
APPRAISAL REPORT
77
Commissioning and
start-up
Pre-production
marketing
Training
Construction
Pre-investment phase stages
Ideas/identification of investment
opportunities opportunities
Analysis of project alternatives and
preliminary project selection (pre-feasibility-
phase)
Project preparation (feasibility study)
P j t i l d i t t d i i
78
Project appraisal and investment decisions
(appraisal report)
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40
Investment phase stages
Establishing the legal, financial and
organizational basis for the implementation of organizational basis for the implementation of
the project
Technology acquisition and transfer
Detailed engineering design and contracting
Acquisition of land, construction work and
installation
79
Pre-production marketing
Recruitment and training
Plant commissioning and start up
Operational phase stages
Initial period after start-up (short-term view)
Adaption of production techniques Adaption of production techniques
Operational difficulties with equipment
Low labour productivity
Full production (long-term view)
Review of chosen strategies and related
production and marketing costs as well as
80
p g
sales revenues
Comparison of projections made at the pre-
investment phase with reality
Remedial measure either difficult or expensive
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41
Total investment costs
A. Pre-production expenditures
B + Fi d i t t t B. + Fixed investment costs
land
equipment
technology
buildings
C Fi d t (A B)
81
C. = Fixed assets (A+B)
D. + Net working capital
E. = Total investment costs (C+D)
TOTAL INVESTMENT COSTS TOTAL ASSETS
Production and marketing costs
material inputs (usually direct and variable costs)
+ human resource costs (fixed or variable costs)
+ factory overheads (direct/indirect, fixed/variable)
services
royalties
R + D
etc.
= factory costs
+ administrative overheads (indirect and fixed costs)
82
( )
= operating costs
+ depreciation
+ costs of financing
= production costs
+ marketing costs (direct/indirect)
= total costs of products sold
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Interrelationship between
components of the feasibility study
83
Information flow chart for the
preparation of feasibility studies
84
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Financial analysis and investment
appraisal
A. Scope and objective of financial analysis
B. Principal aspects of financial analysis and concept of p p y p
investment appraisal
C. Analysis of cost estimates
D. Basic accounting statements
E. Methods of investment appraisal
F. Liquidity planning
G. Project financing
H Ratio analysis
85
H. Ratio analysis
I. Financial analysis under conditions of uncertainty
J. Indicators of upcoming financial problems
K. Economic evaluation
Methods of evaluation of
investments
Static
ROA Return on Assets
ROE Return on Equity
ROI Return on Investment
ROS Return on Sale
PP Payback Period
Dynamic
86
Dynamic
NPV Net Present Value
IRR Internal Rate of Return
MIRR Modified Internal Rate of Return
other modifications
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Project appraisal:
net present value and internal rate of return
Theoretical justifications for using discounted cash flow techniques in
analysing major investment decisions analysing major investment decisions
Opportunity cost of capital
Calculate net present value and internal rate of return
The relationship between net present value and internal rate of return
Two potential problems that can arise with internal rate of return
Net Present Value NPV

n
CF

=
+
=
t
t
d
t
r
CF
NPV
0
) 1 (
0 > NPV
88
max NPV
2014-01-09
45
Ilustrationof NPV idea
89
Internal Rate of Return IRR
( ) ( )
2 1
1 2 1
1
IRR
NPV NPV
r r NPV
r
+

+ =
r
1
, r
2
discounted rates; r
1
< r
2
,
NPV iti l ( )
90
NPV
1
positive value (+)
NPV
2
negative value (-)
2014-01-09
46
Internal rate of return
CF
1
CF
2
CF
3
CF
Outlay = Future cash flows discounted at rate r
CF
0
=
CF
1
1 + r
+
CF
2
(1 + r)
2
CF
3
(1 + r)
3
+
CF
n
(1 + r)
n
.
The internal rate of return, r, is the discount rate at which
the net present value is zero
CF
0
+
CF
1
1 + r
+
CF
2
(1 + r)
2
CF
3
(1 + r)
3
+
CF
n
(1 + r)
n
.
= 0
1 + r (1 + r) (1 + r)
3
(1 + r)
IRR IRR graphic graphic interpretation interpretation




[]










NPV1


r2
0 r [%]
IRR
r1 rgr



NPV2


NPV < 0
NPV > 0
NPV= 0
2014-01-09
47
Graph of NPV
Problems with internal rate of return
Multiple solutions
Internal rates of return are found at 11.56 per cent and 288.4 per cent
2014-01-09
48
Problems with internal rate of return (2)
Ranking
Key points
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49
Key lecture points (continued)
Modified Internal Rate of Return MIRR
1
) 1 (
) 1 (
0
0
.

+
+
=

n
t
d
n
t
n
t
t n
rei t
r COF
r CIF
MIRR
98
0 = t
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50
Modified Internal Rate of Return MIRR
MIRR>rd approval of investment
MIRR<rd reject of investment
MIRR=rd farther information needed
99
Modified Net Present Value
(MNPV)
( ) 1 rei NCF
N
t N
+

rei reinvestment rate of cash inflow,
NCF
0
capital expenditures,
N number of years of the project,
( )
( )
0
1
1
1
NCF
r
rei NCF
MNPV
N
t
t

+
+
=

=
100
N number of years of the project,
t time
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51
Profitability index
NCF
(+)
positive CF,
NCF
()
negative CF,
r discount rate
( )

=
+
+
=
N
N
t
t
t
NCF
r
NCF
PI
) (
0
) (
1
101
( )

=
+
t
t
t
r
NCF
0
1
Equivalent Annual Annuity- EAA
One of two methods used in capital budgeting to
compare mutually exclusive projects with unequal compare mutually exclusive projects with unequal
lives.
The equivalent annual annuity (EAA) approach
calculates the constant annual cash flow generated
by a project over its lifespan if it was an annuity.
The present value of the constant annual cash flows
is exactly equal to the project's net present value is exactly equal to the project s net present value
(NPV).
When used to compare projects with unequal lives,
the one with the higher EAA should be selected.
102
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52
EAA thecalculationmethod
1. Calculate each project's NPV over its
lifetime lifetime.
2. Compute each project's EAA, such that the
present value of the annuities is exactly
equal to the project NPV.
3. Compare each project's EAA and select the
one with the highest EAA one with the highest EAA.
103
EAA formula
NPV
NPV
NPV net present value of the project
( )

+
=
=
N
t
t
r
NPV
EAA
1
1
1
( )
N
r
NPV r
EAA

+
-
=
1 1
p p j
r discount rate
N the last period of time of lifecycle of the
project
104
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53
INVESTMENT FINANCIAL
MODELING
105
Investment valuationmodel (IVM)
The basic mathematical technique of finance
that calculates the value of an investment as that calculates the value of an investment as
the present value of all future cash flows
expected to be generated by the investment
An IVM computes this value as the present
value of all returns the investment is likely to value of all returns the investment is likely to
generate.
This can help in making investment
decisions.
106
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54
What isIVM
A IVM is a projection of investments, incomes
and expenses for a given enterprise or and expenses for a given enterprise or
project that is organized in an electronic
worksheet.
107
Why are IVM developed?
IVMs are used to forecast financial profitability levels
and other financial parameters of interest. and other financial parameters of interest.
They are also used to understand how profitability is
affected by changes in volume, prices and costs
(sensitivity analyses).
The most widely used financial profitability
parameters are the Net Present Value (NPV) and the
Internal Rate of Return (IRR) Internal Rate of Return (IRR).
108
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Why are IVM developed?
We may want to know if investing in a given
business will provide us with a higher return business will provide us with a higher return
than leaving our funds where they are.
We may wish to compare the return of two or
more investment alternatives.
109
How do we develop Investment
ValuationModels?
Preliminary decisions include:
j t lif t b li ti project life: must be realistic
production capacity: start small; depends on
investment capacity also
capacity utilization: usually increases over
time
inflation rate: consider or not; either way,
results will have to be interpreted accordingly
110
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56
How do we develop Investment
ValuationModels?
Determine investment requirements,
including working capital including working capital
Buy new? Buy second-hand? Lease? Rent?
Working capital requirements are a function
of volume, costs, inflation and terms of
payment
W ki it l l d t t th Working capital leaves and returns to the
enterprise, with the production and selling
cycles
Define the residual value of assets; be
conservative
111
How do we develop Investment
ValuationModels?
We have to estimate sales volume; be
conservative conservative
We have to determine the business cost
structure
In general, rural farmers and producers lack
this information
V i bl t h h d it t t Variable costs: how much does it cost to
produce a unit of output?
Assign costs to everything: include
opportunity cost of family labor
Fixed costs and taxes if pertinent
112
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57
How do we develop Investment
ValuationModels?
Organize information as follows:
Unit cost and price matrix (investment variable Unit cost and price matrix (investment, variable
or production costs, sales prices)
Quantity matrix (investment, variable or
production costs, yield)
Income and cost matrix (multiply first two
matrices) matrices)
Incorporates fixed costs and taxes; similar to
income statement
Cash flow series without financing
Cash flow series with financing 113
How do we develop Investment
ValuationModels?
Unit and
cost
matrix
Quantity
matrix
Income
and
cost matrix
114
Cash Cash flow flow
series series
NPV NPV or or IRR IRR or or
other other ratios ratios
2014-01-09
58
How do we develop Investment
ValuationModels?
The Income and cost matrix
Investment Investment
Residual value if pertinent
Net sales income
minus variable costs, production costs (includes
transportation)
minus marketing costs minus marketing costs
minus fixed costs (includes maintenance)
115
How do we develop Investment
ValuationModels?
The Income and cost matrix:
D t i l d d i ti it t h Do not include depreciation; its not a cash
flow
Depreciation is only an accounting figure
When calculating pure profitability, do not
include financing
Separate investment decision from financing
one
116
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59
Project appraisal: cash flow
Identify and apply relevant and incremental cash
flows in net present value calculations flows in net present value calculations
Recognize and deal with:
Sunk costs
Incidental costs
Allocated overheads
Quality of information
Information varies greatly in its reliability, which often
depends upon its source p p
The financial manager or analyst is often dependent on
the knowledge and experience of other specialists
Relevance
Completeness
Consistency
Accuracy Accuracy
Reliability
Timeliness
Low cost of collection compared with benefit to be
gained by gathering more detail
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60
Are profit calculations useful for
estimating project viability?
Accountants often produce a wealth of numerical information
Managers are often familiar with the notion of the bottom line g
Manager performance is judged using profit
However profitable is not the same as achieving shareholder
wealth maximisation
Depreciation
Exhibit: An example of adjustment to profit and loss account
2014-01-09
61
Working capital
Net operating cash flow
2014-01-09
62
ABC plc: an example of profit to cash flow conversion
Exhibit: ABC plc: an example of profit to cash flow conversion
ABC plc: an example of profit to cash flow conversion
2014-01-09
63
ABC plc: an example of profit to cash flow conversion
Incremental cash flows
Include all opportunity costs
Include all incidental effects
Ignore sunk costs Ignore sunk costs
Be careful with overheads
Dealing with interest
2014-01-09
64
Lecture review
Raw data have to be checked for accuracy, reliability, timeliness,
expense of collection etc expense of collection, etc.
Depreciation is not a cash flow and should be excluded.
Profit is a poor substitute for cash flow.
Analyse on the basis of incremental cash flows.
Opportunity costs
Incidental effects
Sunk costs
Allocated overhead
Interest
128
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65
Project appraisal: applications of NPV
The replacement decision/the replacement cycle
Th l l ti f l i l t iti The calculation of annual equivalent annuities
The make or buy decision
Optimal timing of investment
Fluctuating output situations
The replacement decision
Amtarc plc produces Tarcs with a machine which
has a useful life of four more years before it will be has a useful life of four more years before it will be
sold for scrap, raising 10,000.
Q-2000 cost of 800,000 payable immediately.
Existing machine secondhand value: 70,000.
The Q-2000 will have a life of four years before
being sold for scrap for 20,000. g p ,
Q-2000 has lower raw material wastage and its
reduced labour requirements.
Selling price and variable overhead will be the
same as for the old machine.
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66
Amtarc: accountants figures
Q-2000 reduces raw material buffer stocks by 120,000.
Corporate Financial
Management 4/e, Copyright
Pearson Education 2008
Redundancy payments of 50,000 will be necessary after one year.
The required rate of return is 10 per cent.
To simplify the analysis sales, labour costs, raw material costs and
variable overhead costs all occur on the last day of each year.
Amtarc plc
Required:
Using the NPV method decide whether to continue using the old
machine or to purchase the Q-2000.
Note the irrelevant information:
1 Depreciation is not a cash flow
2 The book value of the machine is merely an accounting entry
2014-01-09
67
NPV
Incremental cash flow table
Replacement cycles
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68
Replacement cycles (continued)
Replacement cycles: present values
2014-01-09
69
Replacement cycles: annual equivalent annuity
PV = A af
9,845.98
A =
or A =
Three-year replacement:
2.4869
= 3,959.14
PV
af
Replacement cycles: AEAs
2014-01-09
70
When to introduce a new machine
When to introduce a new machine (continued)
2014-01-09
71
Timing of projects
The make or buy decision
Davis and Davies plc
Buy in the eyes for the rods at 1 per set
Use 100,000 sets per annum
To produce their own eyes
Spend 40,000 immediately on machinery etc.
Machinery will have a life of four years
Annual cost of production of 100,000 sets will be 80,000, 85,000,
92,000 and 100,000 respectively
Bought-in components estimates are 105,000 for year 1, followed by
120,000, 128,000 and 132,000 for years 2 to 4 respectively, for
100,000 sets per year
New machinery will be installed in an empty factory the open market
rental value of which is 20,000 per annum
The firms cost of capital is 11 per cent
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72
The make or buy decision (continued)
Fluctuating output
Potato Sorting Company
Summer and autumn: its two machines work at full capacity,
hi h i th i l t f 20 000 b hi which is the equivalent of 20,000 bags per machine per year
In the six months of the winter and spring the machines work
at half capacity
Operating cost of the machine per bag is 20 pence
Very long productive life, yet no secondhand value
Fastsort has an identical capacity to the old machine but its running
cost is only 10 pence per bag
Productive indefinitely Productive indefinitely
Cost 12,000 each to purchase and install
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73
Production managers plan to replace with 2 Fastsorts
Production managers plan to replace with 2 Fastsorts (continued)
2014-01-09
74
Replacing only one old machine
Remarks
The replacement decision
A l i l t iti (AEA) Annual equivalent annuities (AEA)
Optimal replacement cycle
Whether to repair or buy a new machine
Timing of projects
Fluctuating output
Make or buy decision
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75
The decision-making process for investment appraisal
Empirical evidence on project appraisal techniques used
The calculation of payback, discounted payback and accounting rate of return
(ARR)
The drawbacks and attractions of payback and ARR
The balance to be struck between mathematical precision and imprecise
reality
The capital-allocation planning process
Appraisal techniques
2014-01-09
76
Payback
The payback period for a capital investment is the length of time
before the cumulated stream of forecasted cash flows equals the
i iti l i t t initial investment.
Payback
Project A: 4 years, Project B: 4 years, Project C: 5 years.
Tradfirm: Net Present Values (m)
Exhibit: Tradfirm: Net Present Values (m)
2014-01-09
77
Drawbacks of payback
It makes no allowance for the time value of moneyy
Receipts beyond the payback period are ignored
Arbitrary selection of the cut-off point
Discounted payback: Tradfirmplc (m)
Exhibit: Discounted payback: Tradfirm plc (m)
2014-01-09
78
Reasons for the continuing popularity of payback
Supplements the more sophisticated methods
E g an early stage filter E.g. an early stage filter
It is simple and easy to use
Projects which return their outlay quickly reduce the exposure
of the firm to risk
If funds are limited, there is an advantage in receiving a return
on projects earlier rather than later j
It is often claimed that the cash flows in the first few years of a
project provide some indication of the cash flows in later years
Accounting rate of return (ARR)
The accounting rate of return (ARR) method may be
known by other names such as the return on capital y p
employed (ROCE) or return on investment (ROI)
ARR is a ratio of the accounting profit to
the investment in the project, expressed as a
percentage
The decision rule is that if the ARR is greater than or The decision rule is that if the ARR is greater than, or
equal to, a hurdle rate then accept the project
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79
Timewarp plc
Invest 30,000 in machinery: life of three years
Time warp plc (continued)
(5,000 + 5,000 + 5,000)/3
ARR = 100 = 33.33%
15,000
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80
Drawbacks of accounting rate of return
Wide-open field for selecting profit and asset definitions
Profit figures are very poor substitutes for cash flow
Fails to take account of the time value of money
High degree of arbitrariness in defining the cut-off or
hurdle rate
Drawbacks of accounting rate of return (continued)
Accounting rate of return can lead to some perverse decisions
Suppose that Timewarp uses the second version the total investment Suppose that Timewarp uses the second version, the total investment
ARR, with a hurdle rate of 15 per cent
The appraisal team discover that the machinery will in fact generate
an additional profit of 1,000 in a fourth year
Original situation
(5,000 + 5,000 + 5,000)/3
ARR = = 16.67%. Accepted
New situation
p
30,000
(5,000 + 5,000 + 5,000 + 1,000)/4
ARR = = 13.33%. Rejected
30,000
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81
Reasons for the continued use of accounting rate of returns
Managers are familiar with this ancient and Managers are familiar with this ancient and
extensively used profitability measure
Divisional performance and the entire firm is often
judged on a profit-to-assets employed ratio
Internal rate of return: reasons for continued popularity
Psychological
IRR can be calculated without knowledge of the
required rate of return
Ranking
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82
The science and the art of investment appraisal
Strategy
Social context
Expense
Stifling the entrepreneurial spirit
Intangible benefits
The investment process pre-appraisal
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83
The investment process post-appraisal
Post-completion audit
Post-completion auditing is the monitoring and evaluation of the
progress of a capital investment project through a comparison of the
actual cash flows and other costs and benefits with those forecasted actual cash flows and other costs and benefits with those forecasted
Reasons for carrying out a post-completion audit:
1 Financial control mechanism
2 Insight gained may be useful for future capital investment
decisions
3 The psychological effect
2014-01-09
84
Remarks
Payback and ARR are widely used methods of project appraisal, but
discounted cash flow methods are the most popular
M l fi h i l h d Most large firms use more than one appraisal method
Payback
Drawbacks
Attractions
Accounting rate of return
Drawbacks
Attractions
Internal rate of return
Mathematical technique is only one element needed for successful
project appraisal
The investment process is more than appraisal. It has many stages