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29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis,...

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21 March 2022 Project Evaluation 1 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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Page 1: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

18 April 2023 Project Evaluation 1

1. Fundamentals

Decision Making, Cost Theory, Break Even Analysis, Financial

Statements, Financial Ratios, Time Value of Money, Measures of profitability, Comparison of

Alternatives

Page 2: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

18 April 2023 Project Evaluation 2

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

Page 3: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

18 April 2023 Project Evaluation 3

You learn by reading the text, but also by thinking!

Page 4: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

Decision Making

Rekognize/Analyze Decision Problem Define Goal (What) Data Collection Identify Alternatives (How) Select Criteria(s) Assess Risk Make Decision/Select best alternative

18 April 2023 Project Evaluation 4

Page 5: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

Capital Budgeting Decisions

Analyze (see previous slide) Design (loops always necessary) Plan/Market/Finance/Negotiate Invest! Operate/Manufacture => Profit = Economic

Sustainability

18 April 2023 Project Evaluation 5

Page 6: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

18 April 2023 Project Evaluation 6

Cost Concepts

Variable and Fixed Cost Net Profit Contribution Break Even Analysis Economics of Scale Average and Marginal Cost Sunk Costs and Opportunity Costs

Page 7: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

18 April 2023 Project Evaluation 7

Variable and Fixed CostsOperational Costs EstimatesCase Study Example

Variable Costs: Raw Materials 1.4 KUSD/tonLabour Cost 1.2 "Transportation 0.4 "Variable Cost Total 3 "

Fixed Costs:Maintenance 5 MUSD/yearHousing 3 "Management 9 "Sales 3 "Fixed Costs Total 20 "

Page 8: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

Break Even Analysis

Net Profit Contribution (to cover Fixed Cost)

Price Elasticity Optimizing Production Annuity of Investment Cost Economics of Scale

18 April 2023 Project Evaluation 8

Page 9: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

18 April 2023 Project Evaluation 9

Net Profit ContributionVariable Costs:

Raw Materials 1.4 KUSD/tonLabour Cost 1.2 "Transportation 0.4 "Variable Cost Total 3 "

Fixed Costs:Maintenance 5 MUSD/yearHousing 3 "Management 9 "Sales 3 "Fixed Costs Total 20 "

Sales Price: 15 KUSD/tonNet Profit Contribution 12 "

Page 10: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

18 April 2023 Project Evaluation 10

Break Even Analysiswithout investment costs:

Future Sales Price 15 KUSD/tonNet Profit Contribution 12 "Break Even Quantity 1.7 Ktons/year

Break Even Analysiswith investment costs:

Annuity of Loans 80 MUSD/yearProfit requirement 40Fixed Costs incl annuity 140 "Break Even incl. annuity 12 Ktons/year

Break Even Example

Page 11: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

18 April 2023 Project Evaluation 11

MUSD/year

250 Revenue

200 Variable + Fixed Cost

150Fixed Cost incl. annuity

100

50

2.5 5.0 7.5 10.0 12.5 15.0Ktons/year

Break Even Analysis Graphics

Page 12: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

18 April 2023 Project Evaluation 12

Economics of Scale

MUSD/year

250 RevenueLower fixed Cost but

200 higher Variable Cost (less automated)

150

100 Variable + Fixed Cost

50 Fixed Cost incl. annuity

2.5 5.0 7.5 10.0 12.5 15.0Ktons/year

Page 13: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

18 April 2023 Project Evaluation 13

Massive and mighty!

Page 14: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

Financing

Equity (Shareholders Funds) Loans:

Regular Annuity Bullet Baloon

WACC

18 April 2023 Project Evaluation 14

Page 15: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

Criteria / Measures

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

18 April 2023 Project Evaluation 15

Page 16: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

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)

18 April 2023 Project Evaluation 16

Page 17: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

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

18 April 2023 Project Evaluation 17

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Cash Flow

Equity Drawdown Dividend

Taxes Interest &Repayment

Loans Drawdown

Sales Costs

Investment

Shareholders

Government Deb t Holders

Company Cash Account

Customers Suppliers

Fixed Assets

Page 19: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

Source&Application of Funds 1

Profit before Tax (from Op Statem) + Depreciation => Funds from Operations + Loans & Equity Drawdown => Funds for Allocation

18 April 2023 Project Evaluation 19

Page 20: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

Source&Application of Funds 2

Allocation: Investment Repayment of Loans Paid Taxes Paid Dividend

=> Total Allocation of Funds

18 April 2023 Project Evaluation 20

Page 21: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

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

18 April 2023 Project Evaluation 21

Page 22: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

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 Movement18 April 2023 Project Evaluation 22

Page 23: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

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 &

Capital18 April 2023 Project Evaluation 23

Page 24: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

Financial Ratios

Debt Management (DR, DSC, LLCR) Liquidity (Current Ratios) Asset Management (Turnover

Ratios) Market Value (P/E, Internal Value) Profitability (ROI, ROE)

18 April 2023 Project Evaluation 24

Page 25: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

18 April 2023 Project Evaluation 25

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

Page 26: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

18 April 2023 Project Evaluation 26

Time Value of Money

Amount today is not equal to same amount after n years

Many reasons: Opportunity to earn interest Inflation Risk Impatience?

Page 27: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

18 April 2023 Project Evaluation 27

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

Page 28: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

18 April 2023 Project Evaluation 28

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

Page 29: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

18 April 2023 Project Evaluation 29

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

Page 30: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

18 April 2023 Project Evaluation 30

NPV Example:Interest

Project A: 10%Year Cash Flow Present Accum.

n An: Value: NPV0 -100 -100.0 -100.01 30 27.3 -72.72 30 24.8 -47.93 30 22.5 -25.44 30 20.5 -4.95 30 18.6 13.7

Sum: 50 13.7Internal Rate of Return 15.2%

Page 31: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

18 April 2023 Project Evaluation 31

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

Page 32: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

18 April 2023 Project Evaluation 32

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)

Page 33: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

18 April 2023 Project Evaluation 33

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%

Page 34: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

18 April 2023 Project Evaluation 34

Relation of IRR to NPV

Interest Net PresentRate Value

0% 50.02% 41.44% 33.66% 26.48% 19.8

10% 13.712% 8.114% 3.016% -1.8 18% -6.2 20% -10.3

Net Present Value

-20.0

-10.0

0.0

10.0

20.0

30.0

40.0

50.0

60.0

0% 2% 4% 6% 8% 10%

12%

14%

16%

18%

20%

Interest Rate

Page 35: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

18 April 2023 Project Evaluation 35

Comparison of investment alternatives Marginal Attractive Rate of Return

(MARR) Problems with uneven lifetimes Incremental Method

Page 36: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

18 April 2023 Project Evaluation 36

To every problem there exists a solution!

Page 37: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

18 April 2023 Project Evaluation 37

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

Page 38: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

18 April 2023 Project Evaluation 38

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

Page 39: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

18 April 2023 Project Evaluation 39

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

Page 40: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

18 April 2023 Project Evaluation 40

Example of Incremental Method

InterestProject B: 10%

YearCash Flow Present Accum.n An: Value: NPV0 -150 -150.0 -150.01 42 38.2 -111.82 42 34.7 -77.13 42 31.6 -45.64 42 28.7 -16.95 42 26.1 9.2

Sum: 60 9.2Internal Rate of Return 12.4%

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18 April 2023 Project Evaluation 41

Difference B – A => IRR < MARR, so A is selected

Project B - A : 10%YearCash Flow Present Accum.

n An: Value: NPV0 -50 -50.0 -50.01 12 10.9 -39.12 12 9.9 -29.23 12 9.0 -20.24 12 8.2 -12.05 12 7.5 -4.5

Sum: 10 -4.5Internal Rate of Return 6.4%

Page 42: 29 April 2015Project Evaluation1 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value.

18 April 2023 Project Evaluation 42

We can´t always be choosy!


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