1. Fundamentals
Decision Making, Cost Theory, Break
Even Analysis, Financial Statements,
Financial Ratios, Time Value of Money,
Measures of profitability, Comparison
of Alternatives
10 March 2016
Project Evaluation
1
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
10 March 2016
Project Evaluation
2
You learn by reading the text,
but also by thinking!
10 March 2016
Project Evaluation
3
Decision Making







Rekognize/Analyze Decision Problem
Define Goal (What)
Data Collection
Identify Alternatives (How)
Select Criteria(s)
Assess Risk
Make Decision/Select best alternative
10 March 2016
Project Evaluation
4
Capital Budgeting Decisions






Analyze (see previous slide)
Design (loops always necessary)
Plan/Market/Finance/Negotiate
Invest!
Operate/Manufacture
=> Profit = Economic Sustainability
10 March 2016
Project Evaluation
5
Cost Concepts






Variable and Fixed Cost
Net Profit Contribution
Break Even Analysis
Economics of Scale
Average and Marginal Cost
Sunk Costs and Opportunity Costs
10 March 2016
Project Evaluation
6
Variable and Fixed Costs
Operational Costs Estimates
Case Study Example
Variable Costs:
Raw Materials
Labour Cost
Transportation
Variable Cost Total
1.4 KUSD/ton
1.2
"
0.4
"
3
"
Fixed Costs:
Maintenance
Housing
Management
Sales
Fixed Costs Total
5 MUSD/year
3
"
9
"
3
"
20
"
10 March 2016
Project Evaluation
7
Break Even Analysis





Net Profit Contribution (to cover Fixed
Cost)
Price Elasticity
Optimizing Production
Annuity of Investment Cost
Economics of Scale
10 March 2016
Project Evaluation
8
Net Profit Contribution
Variable Costs:
Raw Materials
Labour Cost
Transportation
Variable Cost Total
1.4 KUSD/ton
1.2
"
0.4
"
3
"
Fixed Costs:
Maintenance
Housing
Management
Sales
Fixed Costs Total
5 MUSD/year
3
"
9
"
3
"
20
"
Sales Price:
Net Profit Contribution
10 March 2016
Project Evaluation
15 KUSD/ton
12
"
9
Break Even Example
Break Even Analysis
without investment costs:
Future Sales Price
Net Profit Contribution
Break Even Quantity
15 KUSD/ton
12
"
1.7 Ktons/year
Break Even Analysis
with investment costs:
Annuity of Loans
Profit requirement
Fixed Costs incl annuity
Break Even incl. annuity
80 MUSD/year
40
140
"
12 Ktons/year
10 March 2016
Project Evaluation
10
Break Even Analysis Graphics
MUSD/year
Revenue
250
Variable + Fixed Cost
200
150
Fixed Cost incl. annuity
100
50
2.5
10 March 2016
5.0
7.5
10.0
Project Evaluation
12.5
15.0
Ktons/year
11
Economics of Scale
MUSD/year
250
Revenue
Lower fixed Cost but
higher Variable Cost
(less automated)
200
150
100 Variable + Fixed Cost
50
Fixed Cost incl. annuity
2.5
10 March 2016
5.0
7.5
10.0
Project Evaluation
12.5
15.0
Ktons/year
12
Massive and mighty!
10 March 2016
Project Evaluation
13
Financing


Equity (Shareholders Funds)
Loans:





Regular
Annuity
Bullet
Baloon
WACC
10 March 2016
Project Evaluation
14
Criteria / Measures







Return on Investment (/Equity)
Pay Back Period
Financial Statements
NPV, IRR, B/C ....
Multi Criteria Decision Making
Risk Factor
Efficient Frontier (Pareto)
10 March 2016
Project Evaluation
15
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)
10 March 2016
Project Evaluation
16
Operating Statement
Revenue/Income - Costs
 => EBITDA
 - Depreciation, Inventory Movement,...
 - Interest of Loans
 => Profit before Tax (EBT)
 - Income Tax
 - Dividend
 March
=>Net
Profit/Loss
10
2016
Project Evaluation
17

Cash Flow
Shareholders
Equity Drawdown
Government
Dividend
Taxes
Interest & Deb t Holders
Repayment
Company Cash
Account
Loans Drawdown
Sales
Costs
Customers
Suppliers
Investment
Fixed Assets
10 March 2016
Project Evaluation
18
Source&Application of Funds 1





Profit before Tax (from Op Statem)
+ Depreciation
=> Funds from Operations
+ Loans & Equity Drawdown
=> Funds for Allocation
10 March 2016
Project Evaluation
19
Source&Application of Funds 2

Allocation:





Investment
Repayment of Loans
Paid Taxes
Paid Dividend
=> Total Allocation of Funds
10 March 2016
Project Evaluation
20
Source&Application of Funds 3

Changes in Net Current Assets:


Funds – Allocation
Analysis:




Changes
Changes
Changes
Changes
10 March 2016
in
in
in
in
Cash Account
Debtors
Inventory
Creditors
Project Evaluation
21
Alternative Cash Flow

EBITDA


=> Cash Flow before Tax (Project)


- Interest & Repayment of Loans
=> Free (Net) Cash Flow (Equity)



- Changes in Debtors + Creditors
- Paid Dividend
+ Drawdowns – Investment
=> Cash Account Movement
10 March 2016
Project Evaluation
22
Balance Sheet


Assets:
Current Assets:








Cash Account
Account Receivable
Inventory
Total Current A
Fixed Assets
=> Total Assets
10 March 2016
Debt & Capital:


Total Debt




Current Liabilities
Long Term Debt
Equity
Profit & Loss Bal
Total Capital
=> Debt & Capital
Project Evaluation
23
Financial Ratios





Debt Management (DR, DSC, LLCR)
Liquidity (Current Ratios)
Asset Management (Turnover Ratios)
Market Value (P/E, Internal Value)
Profitability (ROI, ROE)
10 March 2016
Project Evaluation
24
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
10 March 2016
Project Evaluation
25
Time Value of Money


Amount today is not equal to same
amount after n years
Many reasons:




Opportunity to earn interest
Inflation
Risk
Impatience?
10 March 2016
Project Evaluation
26
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: F2 = P*(1+r)*(1+r)
After n years: Fn = P*(1+r)^n
Present Value of F: Pn = Fn / (1+r)^n
10 March 2016
Project Evaluation
27
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(An/(1+r)^n)
Should be > 0
10 March 2016
Project Evaluation
28
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
10 March 2016
Project Evaluation
29
NPV Example:
Project A:
Year
n
0
1
2
3
4
5
Sum:
10 March 2016
Interest
10%
Cash Flow
Present
An:
Value:
-100
-100.0
30
27.3
30
24.8
30
22.5
30
20.5
30
18.6
50
13.7
Internal Rate of Return
Project Evaluation
Accum.
NPV
-100.0
-72.7
-47.9
-25.4
-4.9
13.7
15.2%
30
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
10 March 2016
Project Evaluation
31
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 = 113.7
Cost = 100 Benefit/Cost Ratio = 1.137
(must be > 1)
10 March 2016
Project Evaluation
32
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%
10 March 2016
Project Evaluation
33
Relation of IRR to NPV
Interest Net Present
Rate
Value
0%
50.0
2%
41.4
4%
33.6
6%
26.4
8%
19.8
10%
13.7
12%
8.1
14%
3.0
16%
-1.8
18%
-6.2
20%
-10.3
10 March 2016
Net Present Value
60.0
50.0
40.0
30.0
20.0
10.0
0.0
-10.0
-20.0
0%
2%
4%
6%
8% 10% 12% 14% 16% 18% 20%
Interest Rate
Project Evaluation
34
Comparison of investment
alternatives



Marginal Attractive Rate of Return (MARR)
Problems with uneven lifetimes
Incremental Method
10 March 2016
Project Evaluation
35
To every problem there exists
a solution!
10 March 2016
Project Evaluation
36
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
10 March 2016
Project Evaluation
37
Problems with uneven
lifetimes



Determine lifetime (planning horizon)
for each investment alternative
If uneven, use the shortest lifetime =
Tmin in comparison
Estimate salvage value for other
alternatives at end of Tmin and add to
the cash flow
10 March 2016
Project Evaluation
38
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 IRRdiff > MARR
Determine if B/Cdiff > 1
10 March 2016
Project Evaluation
39
Example of Incremental
Method
Interest
Project B:
10%
YearCash Flow
Present
n
An:
Value:
0
-150
-150.0
1
42
38.2
2
42
34.7
3
42
31.6
4
42
28.7
5
42
26.1
Sum:
60
9.2
Internal Rate of Return
10 March 2016
Project Evaluation
Accum.
NPV
-150.0
-111.8
-77.1
-45.6
-16.9
9.2
12.4%
40
Difference B – A => IRR <
MARR, so A is selected
Project B - A :
10%
YearCash Flow
Present
n
An:
Value:
0
-50
-50.0
1
12
10.9
2
12
9.9
3
12
9.0
4
12
8.2
5
12
7.5
Sum:
10
-4.5
Internal Rate of Return
10 March 2016
Project Evaluation
Accum.
NPV
-50.0
-39.1
-29.2
-20.2
-12.0
-4.5
6.4%
41
We can´t always be choosy!
10 March 2016
Project Evaluation
42