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Finance

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19 views27 pages

Finance

Uploaded by

Victor
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Business Start-Up

Project
FINANCE

1
Topics
1. Financial analysis
i. Investments selection
ii. Ratios

2. Accounting
i. Balance sheet
ii. Income statement
iii. Cash flow statement

3. Financial plan
i. Obtaining capital
ii. Presentation of the financial plan

2
Common Ways to Evaluate Projects

1) Payback Period (PP)

2) Net Present Value (NPV)

3) Profitability Index (PI)

4) Internal Rate of Return (IRR)


• Ideally, the evaluation method should:

a) include all cash flows that occur during the life of the
project,

b) consider the time value of money, and

c) incorporate the required rate of return on the project.


Payback Period

• How long will it take for the project to generate


enough cash to pay for itself?

(500) 150 150 150 150 150 150 150 150

0 1 2 3 4 5 6 7 8

Payback period = 3.33 years


Payback Period

• Is a 3.33 year payback period good?

• Is it acceptable?

• Firms that use this method will compare the


payback calculation to some standard set by the
firm.

• If our senior management had set a cut-off of 5


years for projects like ours, what would be our
decision?
Drawbacks of Payback Period

• Firm cutoffs are subjective.

• Does not consider time value of money.

• Does not consider any required rate of return.

• Does not consider all of the project’s cash flows.


Drawbacks of Payback Period

• Does not consider all of the project’s cash flows.

(500) 150 150 150 450 500 300 300 300

0 1 2 3 4 5 6 7 8
• This project is clearly profitable, but we would NOT
accept it based on a 3-year payback criterion!
Other Methods

1) Net Present Value (NPV)


2) Profitability Index (PI)
3) Internal Rate of Return (IRR)

Consider each of these decision-making criteria:


• All net cash flows.
• The time value of money.
• The required rate of return.
Net Present Value

• NPV = the total PV of the annual net cash flows -


the initial outlay

n
FCFt
NPV =
Σ

t=1
(1 + k) t
- IO
Net Present Value

Decision Rule:

• If NPV is positive, accept.

• If NPV is negative, reject.


NPV Example

• Suppose we are considering a capital


investment that costs $250,000 and provides
annual net cash flows of $100,000 for five
years. The firm’s required rate of return is
15%.
Net Present Value
NPV is just the PV of the annual cash flows minus the
initial outflow.

Using TVM:
P/Y = 1 N = 5 I = 15
PMT = 100,000

PV of cash flows = $335,216


- Initial outflow: ($250,000)
= Net PV $85,216
Profitability Index

n
FCFt
NPV =
Σ

t=1
(1 + k) t - IO

n
FCFt
PI =
Σ

t=1
(1 + k) t
IO
Profitability Index
Decision Rule:

• If PI is greater than or equal to 1,


accept.

• If PI is less than 1, reject.


Internal Rate of Return
(IRR)
IRR: The return on the firm’s invested
capital. IRR is simply the rate of return
that the firm earns on its capital
budgeting projects.
Internal Rate of Return (IRR)

n
FCFt
NPV =
Σ

t=1
(1 + k) t - IO

n
FCFt
IRR:
Σ

t=1
(1 + IRR) t = IO
Internal Rate of Return (IRR)
n
FCFt
IRR:
Σ

t=1
(1 + IRR) t = IO

• IRR is the rate of return that makes the PV of


the cash flows equal to the initial outlay.
• This looks very similar to our Yield to Maturity
formula for bonds. In fact, YTM is the IRR of a
bond.
Calculating IRR

• Looking again at our problem:

• The IRR is the discount rate that makes the


PV of the projected cash flows equal to the
initial outlay.

(250,000) 100,000 100,000 100,000 100,000 100,000

0 1 2 3 4 5
IRR with your Calculator

• IRR is easy to find with your financial calculator.

• Just enter the cash flows as you did with the


NPV problem and solve for IRR.

• You should get IRR = 28.65%!


IRR
Decision Rule:

• If IRR is greater than or equal to the required


rate of return, accept.

• If IRR is less than the required rate of return,


reject.
• IRR is a good decision-making tool as long as
cash flows are conventional. (- + + + + +)

• Problem: If there are multiple sign changes in


the cash flow stream, we could get multiple
IRRs. (- + + - + +)

1 2 3
(500) 200 100 (200) 400 300

0 1 2 3 4 5
Summary Problem
• Enter the cash flows only once.

• Find the IRR.

• Using a discount rate of 15%, find NPV.

• Add back IO and divide by IO to get PI.

(900) 300 400 400 500 600

0 1 2 3 4 5
Summary Problem

• IRR = 34.37%.
• Using a discount rate of 15%,
NPV = $510.52.
• PI = 1.57.

(900) 300 400 400 500 600

0 1 2 3 4 5
Relationship of NPV, IRR, PI

The three are closely related

• IRR is the require rate of return (k) when


NPV is set to equal zero

• PI is NPV plus IO then divided by IO


Indicators
1) Profits / Invested Capital -equity (ROE) (1= 2 X 3)

2) Profits / Sales

3) Sales / Invested Capital

4) Sales / Fixes Assets

5) Sales / Inventories (stocks)

6) Sales / Number of workers

7) Profits / Number of workers


Ratios
1) EBITA / Average Assets
2) EBITA / Interest Expense
3) EBITA Margin
4) (FFO + Interest Expense) / Interest Expense
5) FFO / Debt
6) RCF / Debt
7) Debt / EBITDA
8) Debt / Book Capitalization
9) Operating Margin
10) CAPEX / Depreciation Expense
11) Revenue Volatility
EBITA: Earnings Before Interest, Tax Amortization; FFO: Funds From
Operations (=Cash flow); RCF: Retained Cash Flow (non
considering dividents); Operating margin: Operating income
(earnings before interest and tax) divided by sales; Capital
expenditure -amount a company spends on buying fixed asset

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