Investment appraisal methods p2

INVESTMENT

www.antonioalcocer.com
@antonioalcocer
appraisal

INVESTMENT APPRAISAL METHODS

1. NET PRESENT VALUE (NPV)
2. INTERNAL RATE OF RETURN (IRR)
3. PAYBACK PERIOD

(*) Most important discussed

GOLDEN RULE

“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.com
Cash-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 simplified
P&L and Net Income are affected due to the accounting methods used
Net income is an opinion due to it depends on the calculation
of the cost of goods sold, amortization method used & impairment
Net income is not real cash-flow outlays of money www.antonioalcocer.com
Depreciation, amortization & impairment are not real cash-flow outlays

“So
now
I understand
in investment appraisal
we use CASH-FLOWS”

But how many
cash-flows exist?


Free CASH-FLOW of the project (FCFF)=

Available “$” for the funds providers:
_BANKS
_SHAREHOLDERS


Free CASH-FLOW of the project (FCFF)=

+EBIT (1-t) X

+D&A
+/-WORKING CAPITAL CHANGE

-CAPEX

FCFF= 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 assets
t=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:
_SHAREHOLDERS


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 shareholders
T.S. REPUR= Treasury stock repurchase

…and many others


NOW
WE ARE READY
FOR AN EXAMPLE!


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.com
Yearly data

Houston, we have a problem:
Funding needed:
$300 mill. in 1st year
$150 mill. in 2nd year


Don’t worry
Funds providers:
_banks
_shareholders
will gently dispose
them


“OK, have your funds, but [BANK]
at a 6.6% annual interest rate
rat
& maximum amount 65%

Kd= 6.6%


Ke= 20% [SHAREHOLDERS]

“OK, have your funds,
but at a 20% annual
interest rate & 35%
maximum amount”


So,
which amount/ratio should I ask for
Don E. Botín [banks]
& Don C. Slim [shareholders]?


It seems clear that
The cost of financing this project
Would be the
Weighted average
Cost of capital

WACC


OPTIMAL FINANCING STRUCTURE

[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 debt
WACC= 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%


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%
450

Data in millions of US$
Yearly data

Noooooo!!!!!!!!!

TIME
VALUE
OF MONEY


INVESTMENT APPRAISAL METHODS

1. NET PRESENT VALUE (NPV)
3. PAYBACK PERIOD

(*) Most important discussed www.antonioalcocer.com

1. NET PRESENT VALUE = NPV www.antonioalcocer.com

1) All FCFF are discounted to today & summed
2) Using compound interest formula
3) At a WACC rate

1. NET PRESENT VALUE=$0
[Undertake project]

Cash-flows generated exactly pay the cash-flows expectations requested by
the 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 in
order to meet their profit expectations (NPV=0) & additional cash-flow=NPV
goes as excess profit for shareholders

1. NET PRESENT VALUE<$0
[Do not undertake project]

Cash-flows generated are not enough
to pay the cash-flows demmands by
funds providers according to their
profit 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%)^3

Yearly data
+$131.2 million of excess cash-flow that shareholders get above their profit (20%) & cash-flow expectations


=
Project’s CAGR

=
_solve NPV=0

_get IRR


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)^3

Yearly data www.antonioalcocer.com
IRR 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<0


3. PAYBACK PERIOD Years to recover
investment…
…you better pay

Expected number of years in order
cumulative (+) cash-flows>=
cumulative (-) 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 +225

Payback 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 IRR
Yearly data
Payback period: Positive cumulative cashflows are > negative cumulative cashflows in year 1-2
175/12=14.58
-150/14.58=10.29 months = 10.29/12= 0.85 years


RE

Investment appraisal methods
Project free cashflows

We have learnt: WACC
NPV
IRR
Payback

Thank you very much for you time!
Any comment, suggestion is more than welcome:

Investment appraisal methods p2

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