Investment annalysis

8/9/2019 Investment annalysis

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Investment Analysis


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Financial Costs and Benefits

Based on Time Value of Money

BenefitCost Ratio

Net Present Worth or Net Present Value (NPV)

Internal Rate of Return (IRR)

Risk Analysis

Debt coverage Service Ratio (DCSR)


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Cost-Benefit Analysis

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Scientific criteria to evaluate projects

Determines the scale of the project on the basis of maximation of thedifferences between benefit and cost

Cost-benefit analysis (CBA), or benefitcost analysis (BCA), is used toassess benefits and costs of a project

Purpose of CBA is;

Determine if it is a sound investment/decision

Basis to compare projects. Compares the total expected cost of each optionagainst the total

expected benefits, to see whether the benefits outweigh the costs,and by how much.

CBA focuses on economic efficiency

Calculates net benefits for each project

to describe and quantify the social advantages and disadvantages of the policy

in terms of a common monetary unit


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Criteria for CBA There are 4 CBA; - B-C, B-C/1, B/C & B/C B/C is ratio method used to evaluate the project

If B/C=1; the project is marginal.(i.e. just covering the costs) If B/C>1; (Accepted)widely used in markets to reap maximum benefits If B/C


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Need of CBA

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Recent government decisions give renewed focus to CBA

Agencies need to build their capacity to use CBA to improve the

quality of regulatory and financial analysis

Greater use of CBA expected by government for regulatory

proposals


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Why is CBA useful?

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Takes a community-wide perspective

Allows the consideration of a range of policy options

Determines which proposal maximises net benefits to the

community

Allows benefits and costs to be compared over time

Represents the costs and benefits accruing to different groups

within the community


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In B/C Ratio, we try to assess how much of our

present costs and benefits are worth at a future

point of time.

The costs and benefits are discounted and

assessed for the present.

Rs.1000 today is not the same as it would be

five years from now.


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Rs.1000 today would have to be something

more than Rs.1000 next year.

How much it should be depend upon the

premium we place on that Rs.1000.

In other words, how much we want to use it

for the present (present consumption) and

how much we want to use it in future?


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You have a proposal to build a 3 power generating station of10 MW each costing 3 million. The expected life of the projectis 10 years, during which, there is adequate demand Site

available is perfectly suited 3 Power PlantsExpected life of project 10 Years

Each 10 Mega Watt Plant costs 3 million

Accessories and Other costs 1 million

Initial Investment ( 3 power stations * each 10 MW cost +accessories cost) 10 million

Over next 10 yrs expected revenue 35 million

Each year expected revenue 3.5 million/annum

Incurring costs for 10 years 15 million

Incurring cost per year (O&M costs) 1.5 million/annum

Total Cost (for DBFO) of the plant (Costs) (3*3+1+15) 25 million

Benefits for 10 years 35 millionBenefits> Costs

Option 1


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You have a proposal to build a 1 power generating station of 60MW. The expected life of the project is 10 years, during which,there is adequate demand Site available is perfectly suited 1 Power Plants

Expected life period 10 years

Each 60 Mega WattPlant costs 13 million

Accessories and Other O&M costs 2 million

Initial investment (1 * each 60 megawatt cost +accessories cost) 15 millionOver next 10 yrs expected revenue 48 million

each year expected revenue 4.8 million/annum

Incurring costs for 10 years 20 million

Incurring cost per year 2 million/annum

Total Cost for DBFO of the plant (Costs) - (1*13+2+20) 35 millionBenefits for 10 years 48 million

Option 2


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Costs and Benefits

Year 1 Total Costs

Total

benefits

Discounting

@10% NPW Costs

NPW

Benefits

1 50 0 0.91 45.45 0.00

2 50 0 0.83 41.32 0.00

3 0 40 0.75 0.00 30.05

4 0 60 0.68 0.00 40.98

5 0 75 0.62 0.00 46.57

100 175 86.78 117.60

Benefits - Costs ratio 1.36 (i.e. PV of B / PV of C)

The total cost of the project is 100 invested in first two years. i.e.50, 50

The total benefits of the project is 175 in which payments are received

for the next three years i.e. 40, 60, 75 respectively. Life period of theproject is 5 years. Calculate CBR taking 10% as an DF and convey

whether Project is accepted or rejected.


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The total cost of the project is 300 invested in first

two years i.e. 175,125. The total benefits of the

project is 600 in which payments are received for

the next three years i.e. 150, 200, 250 respectively.Life period of the project is 5 years. Calculate CBR

taking 10% as an DF and convey whether Project is

accepted or rejected.


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Present value

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The current worth of a future sum of money or

stream of cash flows given a specified rate of return

Future cash flows are discounted at the discount

rate, and the higher the discount rate, the lower the

present value of the future cash flows Present value, also known as present discounted

value

Used to make comparisons between cash flows


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Present Value

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To calculate the present value of any futureamounts Single amount

Varying amounts

Annuities

Present value formula for a single amount is:

1) PV = FV (1 + i)-n (or)

2) PV = FV x [ 1 (1 + i)

n

]PV = Present valueFV = Future Valuei= rate of interest

n= number of years


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Single Amount - Calculation 1

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1) Calculate the present value (the value at time period) of receiving a single amount of1,000 in 20 years. The interest rate for discounting the future amount is estimated at

10% per year compounded annually.PV=?? FV=1,000

.....

1 year 1 year 1 year 1 year

0 1 2 3 19 20

n = 20 years; i = 10% per year

The answer tells us that receiving 1,000 in 20

years is the equivalent of receiving 148.64

today, if the time value of money is 10% per

year compounded annually.


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Method 1:

PV = FV (1 + i)-n


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Calculation 2

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Calculate the present value of a single amount

of 1,00 at the end of 2 years assuming the

interest rate of 8% per year compounded

annually.


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Calculation 3

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What is the present value of receiving a single amount of 5,000

at the end of three years, if the time value of money is 8% per

year, compounded quarterlyPV=?? FV=5,000

.....

3 months 3 months 3 months 3 months

0 1 2 3 11 12

n = 12 quarters (3 years X 4 quarters each year); i = 2% per quarter

PV= 3,942.45


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Future Value

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Value of an asset or cash at a specified date in thefuture that is equivalent in value to a specifiedsum today

Two ways of calculating future value:

Simple interest For an asset with simple annual interest = Original

Investment x (1+(interest rate*number of years))

Compound interest For an asset with interest compounded annually=

Original Investment x ((1+interest rate)^number ofyears)


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Calculation -1 (using Simple Interest)

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FV= PV*(1+rt)PV=Present value

R= rate of interest

T= time period

1000 invested for 5 years with simple annual

interest of 10% what will be the future value?


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1000 invested for 5 years with compoundedannual interest of 10% what will be the futurevalue?

FV= PV*(1+i)t

PV=Present value

i= rate of interest

t= time period

= 1000*(1+0.10)5

= 1000*(1.10)5

= 1000*(1.610)

=1610.51

Calculation -1 (using Compound

Interest)


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Annuities

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Annuities - series of fixed payments required fromyou or paid to you at a specified frequency over

time period.

Payment frequencies - Yearly, Semi-annually (twicea year), Quarterly and Monthly.

There are two basic types of annuities:

Ordinary annuities : Payments are required at the end of each period. Future Value

Present Value

Annuities due: Payments are required at the beginning of each period.


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Present Value (PV)Ordinary annuities

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To determine today's value of a future payment Calculates the PV of the payments that you will receive in the

future.

Investing 1000 per year for the next 5 years, and investing that at

the 5%

Present value of an ordinary annuity returned a value of 4,329.48.

The present value of an ordinary annuity is less than that of anannuity due because the further back we discount a future

payment, the lower its present value


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Net Present Value

Net Present Value (NPV):The sum of the present valuesof all cash inflows minus the sum of the present values of

all cash outflows.

Appreciates time value of money

Only cash profits are important

Additive method

Provides a direct link between management decision and

shareholder value


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Calculation 1:The total cost of the project is 100 RS invested in

first two years. The total benefits of the project is 175 in which

payments are received for the next three years i.e. 40, 60, 75

respectively. Life period of the project is 5 years.

Year 1

Total

Costs

Total

benefits

Discounting

@10%

Net

benefits

Discounting

NB @10%

1 50 0 0.91 -50 -45.45

2 50 0 0.83 -50 -41.32

3 0 40 0.75 40 30.05

4 0 60 0.68 60 40.98

5 0 75 0.62 75 46.57

100 175 75 117.60

NPV = 30.83???


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Internal Rate of Return (IRR)

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The internal rate of return (IRR): The rate atwhich the sum of discounted cash inflow equalsthe sum of discounted cash out flow.

In other words, it is the rate which discounts thecash flow to zero.

The internal rate of return measures theinvestment yield.


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NPV v/s IRR

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The acceptance and rejection is done base onthe IRR rate

NPV IRR

It takes interest as a known factor It takes interest as a unknown factorIt calculates the exact amount ofinvestment (represents in currency)

It calculates the maximum rate ofinterest (represents in percentage terms

Generates different results wherediscount rates are applicable It gives predictions

NPV is preferred as it is widely used IRR vastly used at corporate level

If NPV>0, then project is accepted innature

IRR is a parameter that can be used torank several projects. The higher the IRRthe most desirable is the project.


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How to Assess

the Internal Rate of Return ?

At what rate the project is profitable?

For this we use the Internal Rate of Return

It is that rate which makes the NPV=0 and the

B/C Ratio =1

IRR represents the average earning power ofmoney used in the project over the project

life.


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Year Costs Benefits

Net

Benefits

DF

@10%

NPV

@10%

DF

@25%

NPV

@25%

DF @

19.00%

NPV

@19%

1 150 0 -150 0.91 -136.36 0.80 -120.00 0.84 -126.05

2 5 25 20 0.83 16.53 0.64 12.80 0.71 14.12

3 5 50 45 0.75 33.81 0.51 23.04 0.59 26.70

4 5 75 70 0.68 47.81 0.41 28.67 0.50 34.90

5 5 125 120 0.62 74.51 0.33 39.32 0.42 50.28

170 275 105 172.66 103.83 126.02


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IRR = {(Lower Discount Rate) + (Difference between

Higher and lower discount rate)} * [NPV at lower

Discount rate/Absolute difference between NPV

At two discount Rates that is total NPVs

IRR = (10) + (15) * [36.2 / (36.2+16.2)]= (10) + 15 * ( 0.69) = 10+10.35

= 20.35%

Formula for IRR


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Once we arrived at the IRR , in this case 20.35%,

we compare that with that of the market rate of

interest.

If the market rate of interest is above this, the

project is rejected.

If it is below this , the project is selected.


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Risks and uncertainties

UncertaintiesDifficult to incorporate in to

project design just because it is uncertain.

RisksWe can take measures to minimise

this.

Risk measurements are very well developed

now.


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Risk Analysis

Here we concentrate only on three issues:

Variations in BenefitsHow much can we

tolerate without dropping a project?

Variations in Costs - How much can we

tolerate without dropping a project?

How much delay the project can afford?


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Risk Analysis

Present value of benefitsPV of Costs

Variations in Benefits = ------------------------------------------------------Present Value of Benefits

Present value of benefitsPV of Costs

Variations in Costs = ------------------------------------------------------Present Value of Costs

Present value of Costs

Variations in time = ------------------------------------------------------

Present Value of Benefits


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94004206

Variations in Benefits = ------------------------- = 55%9400

9400 - 4206

Variations in Costs = -------------------- = 123%4206

4206

Variations in time = ----------------- = 0.45

9400

Using a 10% discount factor, this 0.45 is equivalent to 8 years.

Risk Analysis

Investment annalysis

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