L ESSON 8 – S UMMARY – P ROJECT E VALUATION The importance of Capital Investments Different types of investments The Capital Budgeting components Principles and techniques of the evaluation methodology Computing the Project Cash Flow The CAPEX The Operating cash flow The investment in Working Capital The salvage value of the CAPEX and its residual value The Working Capital residual value The Project Cash Flow 01 FF - LE/LFC/LG/LGM /2014

T HE IMPORTANCE OF C APITAL I NVESTMENTS (1/2) The future of a company depends a lot on the investments that the company does in the present. The expansion of production capacity, the creation of a new business area, or the creation of a subsidiary abroad, just to give some examples of investments, if run well may increase the company's future profitability, but if they are not well analyzed and assessed may jeopardize the future of the company. 02 FF - LE/LFC/LG/LGM /2014

T HE IMPORTANCE OF C APITAL I NVESTMENTS (2/2) Imagine that the company buys a new machine for believing that its sales volume will increase. If this expectation doesn't happen, the machine will be kept without being used. The company will have worse bottom line numbers since it has several costs associated with the new machine without any compensation from revenues and it has to be keeping the pay back of the loan used to finance the machine purchase. So, will see its profitability affected and may have to face some financial distress. The capital investments can be fundamental in creating value for the company and its shareholders. 03 FF - LE/LFC/LG/LGM /2014

D IFFERENT T YPES OF I NVESTMENTS (1/2) The capital investments can represent initial investments, in setting up a company to develop a particular business, or they may be part of an existing company. In this last case can be subdivided into the following categories: Expansion Increase the production capacity, expand the comercial and retail network, entrance in new markets, going abroad, etc. 04 FF - LE/LFC/LG/LGM /2014

D IFFERENT T YPES OF I NVESTMENTS (2/2) Replacement It consists in replacing equipment, vehicles and other assets, with more modern and new ones (more efficient, reducing costs, increasing quality, etc.). Inovation/Diversifying Are projects with the purpose of creating a new business area, either as a result of a particular innovation, whether as a result of a strategy of diversification. 05 FF - LE/LFC/LG/LGM /2014

C APITAL B UDGETING C OMPONENTS The Capital Investments can have three different components: Non-current Tangible Assets They are typically composed of elements of tangible fixed assets: property, plant, equipment, vehicles, etc. Non-current Intangible Assets Include the elements of intangible nature: patents, trademarks, goodwill, etc. Investment in Working Capital Represents the investment in Working Capital that is required throughout the project in order to develop the normal operating activity associated with the investment. 06 FF - LE/LFC/LG/LGM /2014

P RINCIPLES AND T ECHNIQUES OF THE E VALUATION (1/4) The project evaluation methodology must comply with the following principles: Evaluating Technique: Free Cash Flows, not earnings The project will be evaluated in terms of its generated cash flows. What will be identified is the annual cash flow from the project in each year of its life. Nominal Cash Flow vs. Real Cash Flow The Project Evaluation is based on a set of forecasts concerning operating activity (profit, costs), which can be compiled at current prices or constant prices. At current prices, means that you will need to estimate the annual evolution of prices (sales prices, prices of inputs, wages, etc.) in accordance with the expected inflation rates, obtaining Nominal Cash Flows; the constant price assumes that the prices will be the same during the life of the project (zero inflation), generating Real Cash Flows. 07 FF - LE/LFC/LG/LGM /2014

P RINCIPLES AND T ECHNIQUES OF THE E VALUATION (2/4) Horizon for the analysis Each project has a certain lifetime, i.e., a horizon of analysis; the most common criterion for the determination of the horizon is the expected economic life for the main component of the investment. End of the Project It is assumed that at the end of its lifetime the project is finished, i.e., there is a liquidation of all assets, at the price at which they can be sold (which will be estimated at the beginning); this liquidation takes place in the year following the end of the operating activity of the project. 08 FF - LE/LFC/LG/LGM /2014

P RINCIPLES AND T ECHNIQUES OF THE E VALUATION (3/4) Depreciation and the tax rules Depreciation are a cost that do not represent any cash outflow (payment), and because the evaluation technique only looks at cash flows, we could say that Depreciation is not any relevant itself to the project evaluation. However, by the fact of being a cost, Depreciation makes possible the payment of less income taxes; thus, in its quantification one should follow the tax rules (for example, if the IRS allows us to depreciate in 4 years an equipment that might have an economic life of 6 years, we should depreciate it in 4 years); 09 FF - LE/LFC/LG/LGM /2014

P RINCIPLES AND T ECHNIQUES OF THE E VALUATION (4/4) Financing The Project We will for now assume that the project is financed entirely by equity. In this way, will seek to analyze the project on its own merits (the quality of the business itself: economic evaluation), not influencing the evaluation by the financing decision. Only in a second stage it is taken into account the way of financing the project and the impact of that in the final evaluation (financial evaluation). 10 FF - LE/LFC/LG/LGM /2014

C OMPUTING THE P ROJECT C ASH F LOWS : P RINCIPLES (1/2) When computing the Cash Flow one must follow the following principles / point of view: Cash The cash flows represent inflows and outflows of cash (receipts and payments) and not income or costs. Incremental Should only be considered the incremental cash flows, i.e., only those resulting from the implementation of the project and without which they would not exist. In the case of a project that is part of an existing firm, one should determine the difference between the cash flows with and without project. Following this reasoning, "sunk costs" and "allocated costs" should be ignored and the opportunity costs and side effects should be included. 11 FF - LE/LFC/LG/LGM /2014

C OMPUTING THE P ROJECT C ASH F LOWS : P RINCIPLES (2/2) “Sunk costs” Are costs that have already occurred before the project evaluation. Should not be included in the analysis because they are not incremental, they are in the past and are the same either the project is accepted or rejected. Opportunity Costs Sometimes, the allocation to the project of certain existing assets can lead to a "loss" of an opportunity to use and get value out of the same assets in a different way. The value that will be forgone if the project is adopted has to be included in the evaluation. Side Effects Undertaking an investment in an existing firm can generate positive (e.g. synergies) or negative (e.g. cannibalization) effects. These effects should be considered in determining the cash flows. 12 FF - LE/LFC/LG/LGM /2014

C OMPUTING THE P ROJECT C ASH F LOWS : THE CAPEX (1/2) Are considered expenditure on fixed assets, both tangible (e.g. buildings, machinery) and intangible (e.g. installation costs, market analysis). Although the investment is mostly done at the beginning of the project, there may be situations in which the investment is spread over several periods, or situations of reinvestment. It is assumed usually the reinvestment for tangible assets, which economic life is less than the duration of the project. On the other hand, it is not assumed the reinvestment of intangible assets. Reinvestment will be held at the price the equipment has at the beginning of the evaluation (at constant prices) or taking into account that price and the expected inflation for the future years (at current prices). CAPEX has a negative impact on the cash flows of the project as it represents an outflow of cash. 13 FF - LE/LFC/LG/LGM /2014

C OMPUTING THE P ROJECT C ASH F LOWS : THE CAPEX (2/2) Consider a firm that will undertake today the following CAPEX: What is the impact on the Cash Flows of the project? (consider a 5 year lifetime and zero inflation) And if the forecasted inflation is 2% for the next 5 years? 14 EquipmentValueEconomic Life Machine A €5 years Machine B €4 years Installation Costs €3 years Acquisition at the end of year 4. FF - LE/LFC/LG/LGM /2014

C OMPUTING THE P ROJECT C ASH F LOWS : O PERATING C ASH F LOW (1/2) The operating cash flow derives from the difference between revenues and operating cash costs, deducted by the income tax. Assuming that the income tax is paid in its corresponding year, then: OCF = EBIT – Income Tax + Depreciation On the first stage of a project evaluation (the economic analysis of the business) it is assumed that the financing is all with equity, ignoring any finance expense. The impact of the OCF in the Cash Flow of the project can be both positive (hopefully) or negative. 15 FF - LE/LFC/LG/LGM /2014

C OMPUTING THE P ROJECT C ASH F LOWS : O PERATING C ASH F LOW (2/2) Consider another firm with Revenues of 1,000 €, a Gross Margin of 60%, Fixed Costs of 500 € (except Depreciation that amounts to 50 €) and it is subject to an income tax rate of 20%. Compute its OCF. Using other ways of calculating it: Or 16 ItemValue 1.Revenues1,000 € 2. Cost of Goods1,000 x (1 – 60%) = 400 € 3. Gross margin (1. – 2.)1,000 x 60% = 600 € 4. Fixed Costs500 € 5. EBITDA (3. – 4.)100 € 6. Depreciation50 € 7. EBIT50 € 8. Income Tax (7. x t)50 x 20% = 10 € 9. NOPLAT (7. – 8.)40 € 10. OCF ( )90 € FF - LE/LFC/LG/LGM /2014

C OMPUTING THE P ROJECT C ASH F LOWS : C HANGE IN W ORKING C APITAL (1/2) The Working Capital is the difference between the Operating Needs and the Operating Resources. On the Operating Needs we usually have: Trade Receivables, Inventory and operating Cash. On the Operating Resources we usually have: Trade Payables and Tax Payables (retentions of labor income tax, social security and VAT). The change in Working Capital will make possible the adjustment of the economic flows still included on the OCF into a cash perspective. A positive change represents an investment (negative impact on the cash flow of the project) and a negative change represents a disinvestment (positive impact on the cash flow of the project). 17 FF - LE/LFC/LG/LGM /2014

C OMPUTING THE P ROJECT C ASH F LOWS : C HANGE IN W ORKING C APITAL (2/2) Consider the following information about the WC of a firm: Compute the WC and its change, identifying in which years there was an investment or a disinvestment in WC. 18 Year 1Year 2 Trade Receiv2015 Inventory1513 Trade Payab1014 Tax Payabl34 Year 1Year 2 Operating Needs = = 28 Operating Resources = = 18 Working Capital35 – 13 = 2228 – 18 = 10 ∆ WC22 – 0 = 2210 – 22 = – 12 Investment in WC, negative impact on the cash flow of the project Disinvestment in WC, positive impact on the cash flow of the project FF - LE/LFC/LG/LGM /2014

C OMPUTING THE P ROJECT C ASH F LOWS : D ISINVESTMENT IN CAPEX (1/2) At the end of the lifetime of the project it is considered that the existing assets can still have a salvage value. In case of not being possible to estimate the market value those assets will have at that future moment, it is assumed that the same shall be equal to the residual accounting value (the book value of the assets at that future moment): Residual Value = Acquisition Price – Accum Depreciation The value of disinvestment in CAPEX should also take into account the existence of accounting profits or accounting losses on the sale of the assets. Accounting profit Tax to pay Accounting lossTax benefit The value to be used for the cash flow of the project must then match the amount by which we will be able to sell the assets, adjusted by the tax to pay or the tax benefit: Disinvestment in Capex = Sale Price – ( Sale Price – Residual Value) x t 19 FF - LE/LFC/LG/LGM /2014

C OMPUTING THE P ROJECT C ASH F LOWS : D ISINVESTMENT IN CAPEX (2/2) Consider the information on Slide14 and the straight-line Depreciation. At the end of the project, the market value of Machine A will be € and of Machine B will be €. The Income Tax rate is 20%. Compute the Disinvestment in CAPEX. Machine A: Machine B: 20 EquipmentAcq price LifeYearly depreciation Acumm deprec Residual Book Value Machine A6005 years600 / 5 = x 5 = – 600 = 0 Machine B (2nd)2004 years200 / 4 = 5050 x 1 = – 50 = 150 Purchased at the end of year 4. Accounting profit Accounting loss FF - LE/LFC/LG/LGM /2014

C OMPUTING THE P ROJECT C ASH F LOWS : WC R ESIDUAL V ALUE (1/2) At the end of the project lifetime there are still the WC values to liquidate: Will be received the values corresponding to the Operating Needs (cash inflow); Will be paid the financial obligations of the Operating Resources, representing a cash outflow. Thus, the WC residual value will correspond to the WC value of the last year of the lifetime of the project. 21 FF - LE/LFC/LG/LGM /2014

C OMPUTING THE P ROJECT C ASH F LOWS : WC R ESIDUAL V ALUE (2/2) Based on Slide 18, compute the WC residual value: The residual value corresponds to the last value of the WC (last year). On year 3, customers will pay the 15 they owe and the goods in inventory will be converted into cash, thus generating a total of cash entries of 28. We will pay what we owe to suppliers, amounting 14, and taxes of 4, resulting in a total cash outflow of 18. Overall we have a positive net value of 10 (28-18). 22 Year 1Year 2 Operating Needs3528 Trade Receivables2015 Inventory1513 Operating Resources1318 Trade Payables1014 Tax payables34 WC2210 ∆ WC Positive value corresponds to positive impact on the cash flow of the project FF - LE/LFC/LG/LGM /2014

C OMPUTING THE P ROJECT C ASH F LOWS : C OMPUTING THE C ASH F LOW The Cash Flow of the Project corresponds to the following calculation on the table below: NN+1 1.Resources ( ) 2. Operating Cash Flow (OCF) Disinvestment in CAPEX Residual Value in Working Capital (WC) Needs ( ) 6. CAPEX 7. Change in Working Capital (∆ WC) Cash Flow of the Project (CF) (1. – 5.) FF - LE/LFC/LG/LGM /2014