FINANCIAL INVESTMENTS ANALYSIS
AND EVALUATION.
Corporate Finance
Castellanza,
20th October and
3rd November, 2010
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Executive Summary
 The investment definition and financial
value of the time
 The Cash-Flow Model
 The Present Value notion
 Capital Budget Techniques
Present value
A dollar tomorrow is worth less than a dollar today.
Why?
1) Present consumption preferred to future consumption – to
induce people to give up to present consumption you have to
offer them more in the future
2) Monetary inflation – the value of currencies decreases over
time
3) Uncertainty (risk) – if there is a risk associated with an
investment in the future, the less the investment will be
valued
Discounting and compounding
Discount rate: it is a rate at which present and future cash flows
are traded off. It incorporates:
 preference for current consumption
 expected inflation
 the uncertainty in the future cash flows
Discounting converts future cash flows into present cash flows.
Cash flows at different points in time cannot be compared and
aggregated. All cash flows have to be brought to the same
point in time, before comparisons and aggregations are made.
Compounding converts present cash flows into future cash flows.
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A Definition:
An Investment is
a transfer of monetary resources over time,
mainly characterized by
net outflows in the first stage, and
net inflows in the following periods.
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An example of flows chart:
F(t)
t
Implementation
Useful life
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Financial dynamics include…
 Current business decision-making;
 Capital budgeting;
 Investment decisions;
 Asset and liability management;
In detail, about Capital budgeting:
 To increase productive capacity;
 To buy or improve plant and machinery (equipment investments
decisions) / To rationalize processes (make or buy decisions);
 To develop and strengthen products and services range;
 Acquisition strategies.
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Capital Budgeting: forces at play
Investment
Opportunities
(real activities)
ENTERPRISE
Risk/Return
Relationship
Other aspects to focus on:
 Fiscal policy;
 Financial requirement.
SHAREHOLDERS
Investment
Opportunities
(financial
activities)
Risk/Return
Relationship
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How to finance investments:
 Self-Financing (A)
 Equity (E)
 Debt (D)
on:
The choice among the sources of fonts is based





Capital supply;
Enterprise conditions;
Economic effects;
Non-economic effects;
Financial flexibility.
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The investment analysis: key stages
1. Scouting among different alternative investments
(strategic and commercial perspective);
2. Evaluation of alternative investments (technical
perspective).
3. Evaluation of the projects according to financial
criteria;
4. Selection of the most profitable projects.
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Key information for a consistent evaluation
In order to efficiently evaluate investments it is important to
have clear information about:
1. Invested capital;
2. Investment duration;
3. Costs and revenues connected to the investment;
4. Cash flow generated by the investment;
5. Terminal value of invested capital at the end of the
investment period;
6. Risk connected to the investment.
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Investments financial analysis
Key drivers:
 risk (connected to every investment)
 return (the “result” generated by the investment)
 time (the investment duration)
 Financial value of time
 Cost of capital (Fundraising)
 Return of capital (Investments)
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Financial value of time
Financial value of time is connected to:
 risk (it is proportional to the probability that future
cash flows will be effectively collected)
 flexibility (possibility to reinvest present cash flow)
 Temporal distribution of value
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Cash flow temporal distribution
F(t)
F(t)
0
1
2
3
4
Time
0
1
2
3
4
Time
Both the investments are characterized by the same outflows;
however, the temporal distribution of the inflows is clearly
different. This feature implies the investments different value.
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Executive Summary
 The investment definition and financial value of the
time
 The Cash-Flow Model
 The Present Value notion
 Capital Budget Techniques
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Key drivers for a consistent evaluation
In order to efficiently evaluate investments it is
important to focus on 3 key drivers:
 The cash flow amount;
 The temporal distribution of the cash flows;
 Financial value of time.
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Relevant cash flows determination
Revenues
- Operating expenses
- Depreciations
= Operating income
- Taxes
= Net Earnings
+ Depreciations
± Change in Net Working Capital (NWC)
= Cash flow from operations
- Investments
+ Divestments
= RELEVANT CASH FLOW
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Guidelines for cash flow determination
 Do not confuse average and marginal returns (focusing only on
marginal returns);
 To take into account “collateral” effects;
 Do not forget to cover the working capital requirement
connected to the investment;
 Do not consider sunk costs;
 To analyze opportunity cost;
 To pay attention on common cost apportionment;
 To consider the present value of the fiscal benefit connected
to amortization.
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Executive Summary
 The investment definition and financial value of the
time
 The Cash-Flow Model
 The Present Value notion
 Capital Budget Techniques
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Present Value
Present Value (PV) is
the value on a given date of a future amount of money,
discounted to reflect the financial value of time.
PV =
Ft
(1 + k)t
where, Ft = cash flow generated by the investment
k = discount rate
1/(1 + k)t = discount factor
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Investment Present Value
PV is a means to compare cash flows
at different times on a meaningful "like to like" basis
F4
F(t)
F3
n
Ft
PV  
t
t 1 1  k 
F2
F1
Tempo
F0
Discount
dove:
Ft
n
k
1/(1+k)
= cash flow on a given date t
= number of period
= discount rate
= discount factor
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Executive Summary
 The investment definition and financial value of the
time
 The Cash-Flow Model
 The Present Value notion
Capital Budget Techniques
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Methods for the investments evaluation
There are different methods to evaluate and to
compare alternative investments, such as:
 The Net Present Value (NPV)
 The Internal Rate of Return (IRR)
 The Pay-Back Period (PBP)
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The Net Present Value (NPV)
The Net Present Value is an indicator of how much
value an investment adds to the enterprise.
It takes into account not only cash inflows generated
by the investment, but also cash outflows needed to
develop the investment plan.
The NPV is the sum of each cash inflow/outflow
discounted back to its present value (PV).
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How to estimate the Net Present Value
1.
To estimate future cash flows of the investment for every
year of the investment project.
2. To estimate discount rate.
3. To discount future cash flows for every year.
4. To sum discounted cash flows (= Present Value of the
investment).
5. The NPV is simply the PV of future cash inflows minus the
cash outflow needed to carry out the investment project.
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The Net Present Value
Supposing an investment plan characterized by five cash inflows
and only a single cash outflow at the beginning, the NPV
formula is:
NPV  F0 
F3
F5
F1
F2
F4




1  k 1 1  k 2 1  k 3 1  k 4 1  k 5
where:
 Ft = cash inflows
 F0 = cash outflow
 k = discount rate
n
Ft
NPV  
t
t 0 1  k 
The Net Present Value
F4
F(t)
F3
F2
F1
Time
F0
Discounting
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The Net Present Value: properties
 The NPV allows to evaluate the added value
generated by the investment plan.
 A project is profitable (in a financial point of view)
only if its NPV has a positive value (NPV>0).
Comparing alternative investments, the one yielding
the higher NPV should be selected.
 A positive NPV points that the project is able to
add value generating more cash inflows than cash
outflows.
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The NPV: PROS and CONS
PROS:
 It takes into account financial value of time
 It considers both future cash flows and capital cost
(troughout the discount rate)
CONS:
 It is not directly connected to the initial investment
 It is based on the “perfect markets” assumption
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The Internal Rate of Return (IRR)
The Internal Rate of Return
is the discount rate thanks to an investment has a
zero Net Present Value.
In other words, it represents the maximum cost of
the fundraising activity, in order to maintain the
project profitability.
In general, an investment whose IRR exceeds its cost
of capital adds value for the company.
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The Internal Rate of Return: formula
IRR: rate of return to project required to obtain an NPV = 0
If IRR > opportunity cost of capital, then accept the project.
n
Ft
0

t
t 0 1  IRR 
The Payback Period (PBP)
 The Payback period requires that the initial outlay of a
project should be recovered within a specified period.
 The PBP is the length of time required to recover the
initial investment of the project.
 If PBP is less than the pre-determined cut-off, accept
the project.