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29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value of Money, Measures of profitability, Comparison of Alternatives

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29 April 2015Project Evaluation2 Overview 1.1 Cost Theory, Break Even 1.2 Financial Statements 1.3 Financial Ratios 1.4 The Concept of Interest 1.5 Profitability Measures 1.6 Comparison of investment alternatives

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29 April 2015Project Evaluation3 You learn by reading the text, but also by thinking!

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Decision Making Rekognize/Analyze Decision Problem Define Goal (What) Data Collection Identify Alternatives (How) Select Criteria(s) Assess Risk Make Decision/Select best alternative 29 April 2015Project Evaluation4

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Capital Budgeting Decisions Analyze (see previous slide) Design (loops always necessary) Plan/Market/Finance/Negotiate Invest! Operate/Manufacture => Profit = Economic Sustainability 29 April 2015Project Evaluation5

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29 April 2015Project Evaluation6 Cost Concepts Variable and Fixed Cost Net Profit Contribution Break Even Analysis Economics of Scale Average and Marginal Cost Sunk Costs and Opportunity Costs

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29 April 2015Project Evaluation7 Variable and Fixed Costs

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Break Even Analysis Net Profit Contribution (to cover Fixed Cost) Price Elasticity Optimizing Production Annuity of Investment Cost Economics of Scale 29 April 2015Project Evaluation8

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29 April 2015Project Evaluation9 Net Profit Contribution

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29 April 2015Project Evaluation10 Break Even Example

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29 April 2015Project Evaluation11 Break Even Analysis Graphics

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29 April 2015Project Evaluation12 Economics of Scale

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29 April 2015Project Evaluation13 Massive and mighty!

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Financing Equity (Shareholders Funds) Loans: Regular Annuity Bullet Baloon WACC 29 April 2015Project Evaluation14

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Criteria / Measures Return on Investment (/Equity) Pay Back Period Financial Statements NPV, IRR, B/C.... Multi Criteria Decision Making Risk Factor Efficient Frontier (Pareto) 29 April 2015Project Evaluation15

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Financial Statements Statement of Earnings/Operating Statement Statement of Cash Flow/Source & Allocation of Funds Balance Sheet Financial Ratios (Assets, Debt, Liquidity, Profitability, Market Value) 29 April 2015Project Evaluation16

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Operating Statement Revenue/Income - Costs => EBITDA - Depreciation, Inventory Movement,... - Interest of Loans => Profit before Tax (EBT) - Income Tax - Dividend =>Net Profit/Loss 29 April 2015Project Evaluation17

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Source&Application of Funds 1 Profit before Tax (from Op Statem) + Depreciation => Funds from Operations + Loans & Equity Drawdown => Funds for Allocation 29 April 2015Project Evaluation19

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Source&Application of Funds 2 Allocation: Investment Repayment of Loans Paid Taxes Paid Dividend => Total Allocation of Funds 29 April 2015Project Evaluation20

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Source&Application of Funds 3 Changes in Net Current Assets: Funds – Allocation Analysis: Changes in Cash Account Changes in Debtors Changes in Inventory Changes in Creditors 29 April 2015Project Evaluation21

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Alternative Cash Flow EBITDA - Changes in Debtors + Creditors => Cash Flow before Tax (Project) - Interest & Repayment of Loans => Free (Net) Cash Flow (Equity) - Paid Dividend + Drawdowns – Investment => Cash Account Movement 29 April 2015Project Evaluation22

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Balance Sheet Assets: Current Assets: Cash Account Account Receivable Inventory Total Current A Fixed Assets => Total Assets Debt & Capital: Current Liabilities Long Term Debt Total Debt Equity Profit & Loss Bal Total Capital => Debt & Capital 29 April 2015Project Evaluation23

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Financial Ratios Debt Management (DR, DSC, LLCR) Liquidity (Current Ratios) Asset Management (Turnover Ratios) Market Value (P/E, Internal Value) Profitability (ROI, ROE) 29 April 2015Project Evaluation24

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29 April 2015Project Evaluation25 The Concept of Interest Time Value of Money Present and Future Value Calculations Net Present Value (NPV) of Cash Flow Series Profitability Measures Comparison of alternatives

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29 April 2015Project Evaluation26 Time Value of Money Amount today is not equal to same amount after n years Many reasons: Opportunity to earn interest Inflation Risk Impatience?

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29 April 2015Project Evaluation27 Present and Future Values Present Value: P, Future Value: F Interest Rate per year: r Future Value after 1 year: F = P*(1+r) After 2 years: F 2 = P*(1+r)*(1+r) After n years: F n = P*(1+r)^n Present Value of F: P n = F n / (1+r)^n

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29 April 2015Project Evaluation28 Net Present Value of Cash Flow Series Invested Capital is Cash Flow out Operations generate Cash Flow in Annual cash in/out: An Net Present Value: NPV = Sum(A n /(1+r)^n) Should be > 0

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29 April 2015Project Evaluation29 NPV Example, Project A: Interest rate = 10% Invested Capital year 0 : -100 MUSD Operations years 1-5 => +30 “ NPV: Year 0: -100 year 1: +30/(1+0.1) = 27.3 year 2: +30/(1+0.1)^2 = 24.8 etc

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29 April 2015Project Evaluation31 Profitability Measures Net Present Value Pay Back Period, discounted Annual Worth / Annuity Benefit / Cost Ratio Internal Rate of Return (IRR) Relation of IRR to NPV

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29 April 2015Project Evaluation32 Profitability measures for the Example Pay Back Period undiscounted = 4 years Pay Back Period discounted = 5 years Annuity of -100 MUSD = 26.4 Annual Cash Flow in = 30.0 Annual Net Worth = 3.6 Benefits = NPV of 30 in 5 years = Cost = 100 Benefit/Cost Ratio = (must be > 1)

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29 April 2015Project Evaluation33 Internal Rate of Return Definition: The interest rate that results in a NPV = 0 Search for r = IRR such that: -100 = sum( 30/(1+r)^n) Interpretation: Earning 30 MUSD per year is equivalent of having 100 MUSD on an account with interest rate of r Here IRR = 15.2%

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29 April 2015Project Evaluation34 Relation of IRR to NPV

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29 April 2015Project Evaluation35 Comparison of investment alternatives Marginal Attractive Rate of Return (MARR) Problems with uneven lifetimes Incremental Method

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29 April 2015Project Evaluation36 To every problem there exists a solution!

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29 April 2015Project Evaluation37 Marginal Attractive Rate of Return (MARR) The lowest acceptable limit for IRR, i.e. IRR should be > MARR MARR is determined by the best available alternative use of money MARR can be IRR of best alternative investment possibility, or loan interest of the most expensive loan

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29 April 2015Project Evaluation38 Problems with uneven lifetimes Determine lifetime (planning horizon) for each investment alternative If uneven, use the shortest lifetime = T min in comparison Estimate salvage value for other alternatives at end of T min and add to the cash flow

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29 April 2015Project Evaluation39 Incremental Method for Comparison NPV measure: Select highest NPV Annual Worth: Same Pay Back Period: Not applicable IRR and B/C measures: Use incremental method, i.e. calculate the difference Determine if IRR diff > MARR Determine if B/C diff > 1

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29 April 2015Project Evaluation40 Example of Incremental Method

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29 April 2015Project Evaluation41 Difference B – A => IRR < MARR, so A is selected

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29 April 2015Project Evaluation42 We can´t always be choosy!

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