Castellanza, 20 th October and 3 rd November, 2010 FINANCIAL INVESTMENTS ANALYSIS AND EVALUATION. Corporate Finance
Jan 05, 2016
Castellanza,20th October and
3rd November, 2010
FINANCIAL INVESTMENTS ANALYSIS AND EVALUATION.
Corporate Finance
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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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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.
A Definition:
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F(t)
t
An example of flows chart:
Implementation
Useful life
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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.
Financial dynamics include…
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ENTERPRISE
SHARE-HOLDERS
Investment Opportunitie
s (financial activities)
Risk/Return Relationship
Risk/Return Relationship
Other aspects to focus on:
Fiscal policy;
Financial requirement.
Capital Budgeting: forces at play
Investment Opportunitie
s (real activities)
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Self-Financing (A) Equity (E) Debt (D)
The choice among the sources of fonts is based on:
Capital supply; Enterprise conditions; Economic effects; Non-economic effects; Financial flexibility.
How to finance investments:
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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.
The investment analysis: key stages
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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.
Key information for a consistent evaluation
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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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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.
F(t)
Time0 1 2 3 4
F(t)
Time0 1 2 3 4
Cash flow temporal distribution
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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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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.
Key drivers for a consistent evaluation
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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 (PV) is
the value on a given date of a future amount of money,
discounted to reflect the financial value of time.
where, Ft = cash flow generated by the investment
k = discount rate
1/(1 + k)t = discount factor
PV = Ft
(1 + k)t
Present Value
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F(t)
Tempo
F0
F1
F2
F3
F4
Discount
n
tt
t
k
FPV
1 1
dove: Ft = cash flow on a given date t n = number of period k = discount rate1/(1+k) = discount factor
Investment Present Value
PV is a means to compare cash flows at different times on a meaningful "like to like" basis
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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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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)
Methods for the investments evaluation
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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:
where: Ft = cash inflows
F0 = cash outflow
k = discount rate
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011111 k
F
k
F
k
F
k
F
k
FFNPV
n
tt
t
k
FNPV
0 1
F(t)
Time
F0
F1
F2
F3
F4
Discounting
The Net Present Value
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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
0
10
n
tt
t
IRR
F
IRR: rate of return to project required to obtain an NPV = 0If IRR > opportunity cost of capital, then accept the project.
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.
The Payback Period (PBP)