1. Fundamentals

24 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


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


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

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


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

Sustainability24 April 2023 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


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 "

Break Even Analysis Net Profit Contribution (to cover

Fixed Cost) Price Elasticity Optimizing Production Annuity of Investment Cost Economics of Scale



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 "


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


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


Economics of Scale

MUSD/year250 Revenue

Lower fixed Cost but200 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


Massive and mighty!

Financing Equity (Shareholders Funds) Loans:

Regular Annuity Bullet Baloon

WACC


Criteria / Measures Return on Investment (/Equity) Pay Back Period Financial Statements NPV, IRR, B/C .... Multi Criteria Decision Making Risk Factor Efficient Frontier (Pareto)24 April 2023 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)


Operating Statement Revenue/Income - Costs => EBITDA - Depreciation, Inventory Movement,... - Interest of Loans => Profit before Tax (EBT) - Income Tax - Dividend =>Net Profit/Loss24 April 2023 Project Evaluation 17


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

Source&Application of Funds 1 Profit before Tax (from Op Statem) + Depreciation => Funds from Operations + Loans & Equity Drawdown => Funds for Allocation


Source&Application of Funds 2 Allocation:

Investment Repayment of Loans Paid Taxes Paid Dividend

=> Total Allocation of Funds


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


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 Movement24 April 2023 Project Evaluation 22

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 & Capital


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

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



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


Time Value of Money Amount today is not equal to same

amount after n years Many reasons:

Opportunity to earn interest Inflation Risk Impatience?


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


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


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


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%


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


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)


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%


Relation of IRR to NPVInterest Net Present

Rate Value0% 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

0.010.020.030.040.050.060.0

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

12%

14%

16%

18%

20%

Interest Rate


Comparison of investment alternatives Marginal Attractive Rate of Return

(MARR) Problems with uneven lifetimes Incremental Method


To every problem there exists a solution!


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


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


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


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%


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%


We can´t always be choosy!

1. Fundamentals

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