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Investment appraisal methods p2

Investment appraisal methods p2



Investment appraisal and company valuation methods for beginners....

Investment appraisal and company valuation methods for beginners.
Concepts such as time value of money, simple interest, compound interest, CARG, cash-flows, WACC, inflation, discounting and capitalizing cash-flows are covered; in order to analyse and determine the economic feasibility of a project and what is the intrinsic or fair value of a company introducing discounted cash-flow techniques and multiples valuation



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    Investment appraisal methods p2 Investment appraisal methods p2 Presentation Transcript

    • INVESTMENTwww.antonioalcocer.com@antonioalcocer appraisal
    • INVESTMENT APPRAISAL METHODS 1. NET PRESENT VALUE (NPV) 2. INTERNAL RATE OF RETURN (IRR) 3. PAYBACK PERIOD www.antonioalcocer.com(*) Most important discussed
    • GOLDEN RULE www.antonioalcocer.com “We always work with cash-flows in investment appraisal”
    • “Cash-flow is a fact, net income just an opinion” -Pablo Fernández IESE-The net income amount is affected by accounting methods & assumptions made(i.e. depreciation & amortization that are not “real” cash inflows or outflows) www.antonioalcocer.comCash-flows are real money “entering” or “exiting” the company or project
    • P&L (*) Net sales -Cost of goods sold GROSS PROFIT HOW GOOD IS YOUR BUSINESS -Selling, General & Administration GENERATING “$” DUE THE OWN -Other operating expenses NATURE OF THE BUSINESS EBITDA -Depreciation & Amortization -Impairment EBIT -Interests FINANCING STRUCTURE INCOME BEFORE TAXES -Taxes CORPORATE TAXES FRAMEWORK NET INCOME(*) P&L=Profit & Loss account simplifiedP&L and Net Income are affected due to the accounting methods usedNet income is an opinion due to it depends on the calculationof the cost of goods sold, amortization method used & impairmentNet income is not real cash-flow outlays of money www.antonioalcocer.comDepreciation, amortization & impairment are not real cash-flow outlays
    • “So now I understand in investment appraisal we use CASH-FLOWS”www.antonioalcocer.com
    • But how many cash-flows exist?www.antonioalcocer.com
    • Free CASH-FLOW of the project (FCFF)= Available “$” for the funds providers: _BANKS _SHAREHOLDERSwww.antonioalcocer.com
    • www.antonioalcocer.com Free CASH-FLOW of the project (FCFF)= +EBIT (1-t) X +D&A +/-WORKING CAPITAL CHANGE -CAPEXFCFF= Real money generated by the project after accounting adjustments (no real cashflows outlays)D&A=Depreciation & Amortization (added because no real cash-outlay happened)CAPEX=Capital Expenditures (Investment in fixed assets)Working Capital Change= Investment in current assetst=Corporate taxes in %(*) Simplified formula of the cashflow, there are other terms: non-cash transactions adjustments, other current assets changes, proceeds from long term assets sales, changes in long term assets; to be considered
    • Equity Free CASH-FLOW (FCFE)= Available “$” for the equity providers: _SHAREHOLDERSwww.antonioalcocer.com
    • www.antonioalcocer.com Equity Free CASH-FLOW (FCFE)= +FCFF +PROCEEDS NEW BANKING DEBT - AMORTIZATION CURRENT DEBT - INTERESTS OF DEBT * (1-t) - DIVIDENDS PAID & T.S. REPUR.FCFE=Equity free cash-flow.Cash-flow available for shareholders after paying the banking funs providers.FCFE would be the money available for shareholdersT.S. REPUR= Treasury stock repurchase
    • …and many otherswww.antonioalcocer.com
    • NOWWE ARE READYFOR AN EXAMPLE!www.antonioalcocer.com
    • Investment appraisal of a project with these free-cashflows + +$300m +$175m +$200m t0=0 t1=1 t2=2 t3=3 -$150m -$300m -Diagram of the project free-cashflows (FCFF)Data in millions of US$ www.antonioalcocer.comYearly data
    • Houston, we have a problem:Funding needed:$300 mill. in 1st year$150 mill. in 2nd year www.antonioalcocer.com
    • Don’t worry Funds providers: _banks _shareholders will gently dispose themwww.antonioalcocer.com
    • “OK, have your funds, but [BANK] at a 6.6% annual interest rate rat & maximum amount 65% Kd= 6.6%www.antonioalcocer.com
    • Ke= 20% [SHAREHOLDERS] “OK, have your funds, but at a 20% annual interest rate & 35% maximum amount”www.antonioalcocer.com
    • So, which amount/ratio should I ask for Don E. Botín [banks] & Don C. Slim [shareholders]?www.antonioalcocer.com
    • It seems clear that The cost of financing this project Would be the Weighted average Cost of capital WACCwww.antonioalcocer.com
    • OPTIMAL FINANCING STRUCTURE www.antonioalcocer.com [BANK] 50% 60% 65% [SHAREHOLDERS] 50% 40% 35% WACC Cheapest 12.31% 10.77% 10%WACC= % equity * expected return on equity + % banking_debt*(1-corporate tax)*cost of banking debtWACC= 35%*20%+65%*(1-30%)*6.6%=10%
    • So the $300 mill. + $150 mill. will be financed by a 65% banking debt by a 35% shareholders’ equity with a WACC=10%www.antonioalcocer.com
    • Profitability of the project = 50% in 3-years? www.antonioalcocer.com +$300m +$175m +$200m t0=0 t1=1 t2=2 t3=3 -$150m -$300m +300 + 175 + 200 - 300 - 150 %return= = 50% 450Diagram of the project free-cashflows (FCFF)Data in millions of US$Yearly data
    • Noooooo!!!!!!!!! TIME VALUE OF MONEYwww.antonioalcocer.com
    • INVESTMENT APPRAISAL METHODS 1. NET PRESENT VALUE (NPV) 2. INTERNAL RATE OF RETURN (IRR) 3. PAYBACK PERIOD(*) Most important discussed www.antonioalcocer.com
    • 1. NET PRESENT VALUE = NPV www.antonioalcocer.com1) All FCFF are discounted to today & summed2) Using compound interest formula3) At a WACC rate
    • www.antonioalcocer.com 1. NET PRESENT VALUE=$0 [Undertake project]Cash-flows generated exactly pay the cash-flows expectations requested bythe banking & shareholders (funds providers)
    • 1. NET PRESENT VALUE>$0 www.antonioalcocer.com[Undertake project]Cash-flows generated pay all the cash-flows requested by fund providers inorder to meet their profit expectations (NPV=0) & additional cash-flow=NPVgoes as excess profit for shareholders
    • www.antonioalcocer.com1. NET PRESENT VALUE<$0 [Do not undertake project]Cash-flows generated are not enoughto pay the cash-flows demmands byfunds providers according to theirprofit expectations (=WACC)
    • 1. Net present value = NPV – WACC=10% www.antonioalcocer.com +$300m +$175m +$200m t0=0 t1=1 t2=2 t3=3 -$150m -$300m Undertake project NPV>0 +300 -150 +175 +200 NPV = $131.2 = -300 + + + (1+10%)^1 (1+10%)^2 (1+10%)^3Diagram of the project free-cashflows (FCFF)Data in millions of US$Yearly data+$131.2 million of excess cash-flow that shareholders get above their profit (20%) & cash-flow expectations
    • 2. INTERNAL RATE OF RETURN (IRR) = Project’s CAGR = _solve NPV=0 _get IRRwww.antonioalcocer.com
    • 2. Internal Rate of Return (IRR) = 32.24% > WACC =10% Undertake project +$300m +$175m +$200m t0=0 t1=1 t2=2 t3=3 -$150m -$300m Solve non-linear equation +300 -150 +175 +200 NPV = $0 = -300 + + + (1+IRR)^1 (1+IRR)^2 (1+IRR)^3Diagram of the project free-cashflows (FCFF)Data in millions of US$Yearly data www.antonioalcocer.comIRR is obtained solving the equation
    • 1&2. Net present value summary IRR>WACC NPV>0 Fund providers more than happy NPV excess for shareholders IRR=WACC NPV=0 Fund providers exactly happy Fund providers unhappy IRR<WACC NPV<0www.antonioalcocer.com
    • 3. PAYBACK PERIOD Years to recover investment… …you better payExpected number of years in ordercumulative (+) cash-flows>= www.antonioalcocer.comcumulative (-) cash-flows
    • 3. Payback period= 1.85 years www.antonioalcocer.com +$300m +$175m +$200m t0=0 t1=1 t2=2 t3=3 -$150m -$300m Cumulative -300 -300+300-150 -300+300-150+175 -300+300-150+175+200 -300 -150 +25 +225Payback period does not take into account time value of money, so it should not be used in a stand alone basis but as complementary info to NPV and IRRDiagram of the project free-cashflows (FCFF)Data in millions of US$Yearly dataPayback period: Positive cumulative cashflows are > negative cumulative cashflows in year 1-2175/12=14.58-150/14.58=10.29 months = 10.29/12= 0.85 years
    • www.antonioalcocer.comRE Investment appraisal methods Project free cashflowsWe have learnt: WACC NPV IRR Payback
    • Thank you very much for you time!Any comment, suggestion is more than welcome: www.antonioalcocer.com