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Financial Analysis

Session on Finance

Sidharth Sinha

Indian Institute of Management, Ahmedabad

The views expressed here are those of the presenter and do not necessarily reflect the views or

policies of the Asian Development Bank (ADB), or its Board of Directors, or the governments they

represent.

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itTime Value of Money

• Money received today is not the same as money to be received in the future.

Money received today can be invested to earn a return. Money to be received in the future is also uncertain

• Discounting is the process of adjusting the value of money to be received in the future for time value and risk.

• The discounted value is called present value.

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itPresent Values

• Present value of $1 to be received at the end of 1 year if the discount rate is 10%

0.9090.1)(11PV

The higher the discount rate, the lower the present value.

• The discount rate is the opportunity cost of not having money now.

• This is the rate you could have earned if you had the money now instead of later.

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itPresent Values

• Present value of $1 to be received at the end of 2 years

• This is also known as the discount factor for 2 years at 10%

0.82620.1)(1

1PV

The longer the time period to receiving the money,

the lower the present value.

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itPresent Values

• Present value of $1 to be received at the end of t years at a discount rate of 10%

• This is also known as the discount factor for t years at 10%

t0.1)(1

1PV

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itPresent Values

• Present value of $10 to be received at the end of 2 years

8.260.8261020.1)(1

11020.1)(1

10PV

Present Value = Cash Flow*Discount Factor

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itPresent Values

Example -

• You just bought a new computer for $3,000. The payment terms are 2 years same as cash. If you can earn 8% on your money, how much money should you set aside today in order to make the payment when due in two years?

$2,572.022(1.08)

3000PV

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itPresent Values

• PVs can be added together to evaluate multiple cash flows.

....2r)(1

2C

1r)(1

1CPV

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itPresent Values

• PVs can be added together to evaluate multiple cash flows.

• Discount rate is 7.7%

265.27172.4292.85

PV 21 077)(1200

.077)(1100

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itPresent Values

Present Value

Year 0

100/1.077

200/1.0772

Total

= $92.85

= $172.42

= $265.27

$100

$200

Year0 1 2

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itNet Present Values (NPV)

Example -

• Assume that the cash flows from the construction and sale of an office building is as follows. Given a 5% required rate of return, create a present value worksheet and show the net present value.

• When there are both positive and negative cash flows the term Net Present Value is used.

320,000100,000170,000

2 Year1 Year0 Year

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itPresent Values

Example (continued)

• Assume that the cash flows from the construction and sale of an office building is as follows. Given a 5% required rate of return, create a present value worksheet and show the net present value.

$25,011TotalNPV

290,249320,000.9072

1.05

12

95,238100,000.9521.05

11

170,000170,0001.00

Value

Present

Flow

Cash

Factor

DiscountPeriod

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itPresent Values

Example (continued)

• Assume that the cash flows from the construction and sale of an office building is as follows. Given a 5% required rate of return, create a present value worksheet and show the net present value.

Present Value

Year 0

-170,000

-100,000/1.05

320,000/1.052

Total = NPV

-$170,000

= -$170,000

= $95,238

= $290,249

= $25,011

-$100,000

+$320,000

Year

0 1 2

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itInternal Rate of Return

Example -

• You can purchase a machine tool for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?

• Internal Rate of Return is that discount rate which makes the Net Present Value of the cash flows equal to 0.

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itInternal Rate of Return

Example (continued) -

• You can purchase a machine tool gadget for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?

02IRR)(1

4,0001IRR)(1

2,0004,000NPV

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itInternal Rate of Return

Example -• You can purchase a machine tool for $4,000. The

investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?

• IRR is that discount rate which makes the NPV equal to 0.

• “Break-even” discount rate

02IRR)(1

4,0001IRR)(1

2,0004,000NPV

28.08%IRR

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itInternal Rate of Return

-2000

-1500

-1000

-500

0

500

1000

1500

2000

2500

10 20 30 40 50 60 70 80 90 100

Discount rate (%)

NP

V (

,000

s)

IRR=28%

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itNet Present Value

• Present value of cash flows at 20% discount rate

• Since 20% < IRR project has a positive NPV

4444,4444,000

2,7771,6674,00020.2)(1

4,0000.2)(1

2,0004,000NPV

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itProject Evaluation

• Forecast after tax free cash flows

• Estimate appropriate discount rate

• Calculate net present value (NPV)

Accept if NPV > 0

• Calculate IRR

Accept if IRR > discount rate

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itExpected Free Cash Flow

• Profit before interest and tax (PBIT) - tax + depreciation =cash from operations Working capital investment Necessary capital expenditure = Free cash flow

• Cash flow available to pay capital providers - equity & debt investors

• Cash flows are uncertain - valuation is based on expected cash flows

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itWeighted Average Cost of Capital (WACC)

• Weighted average cost of capital (WACC)

= Cost of equity * prop of equity

+Cost of debt * (1-tax rate)*prop of debt

• Proportion of equity

= Equity / (Equity + Debt)

• Proportion of debt

= Debt / (Equity + Debt)

• Cost of debt = interest rate paid on debt

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itCost of Equity

• Dividend yield + capital gains

Dividend yield = % (dividend per share /share price)

Capital gains = % increase in share price

• Required return on equity

= risk free rate + risk premium for equity

• Costs of debt, equity and WACC depend on the risk of

cash flows

Investors require higher rates of return for riskier

projects

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itEnhancing Viability

• Increase level of expected free cash flow Increase revenuesReduce costs

• Reduce WACC by reducing risk of cash flows

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itInflation

• Inflation - rate at which prices as a whole are increasing.

• Nominal Interest Rate - rate at which money invested

grows.

• Real Interest Rate - rate at which the purchasing power

of an investment increases.

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itInflation

• Approximation Formula

rate inflation+1rate interest nominal+1=rate interest real1

• Real int. rate ≈ nominal int. rate - inflation rate

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itInflation

Example -• If the interest rate on one year govt. bonds is 5.9% and

the inflation rate is 3.3%, what is the real interest rate?

1 + real interest rate =

1 + real interest rate = 1.025

Real interest rate = .025 or 2.5%

Approximation = .059 - .033 =.026 or 2.6%

1+.059

1+.033

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• Nominal cash flow forecasts take into account changes

in prices of cash flows.

• Real cash flows assume constant price level.