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

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

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

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

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

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

29 April 2015Project Evaluation7 Variable and Fixed Costs

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

29 April 2015Project Evaluation9 Net Profit Contribution

29 April 2015Project Evaluation10 Break Even Example

29 April 2015Project Evaluation11 Break Even Analysis Graphics

29 April 2015Project Evaluation12 Economics of Scale

29 April 2015Project Evaluation13 Massive and mighty!

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

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

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

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

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

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

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

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

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

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

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?

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

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

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

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)

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%

29 April 2015Project Evaluation34 Relation of IRR to NPV

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

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

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

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

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

29 April 2015Project Evaluation40 Example of Incremental Method

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

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