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 discussedwww.antonioalcocer.com

“We always work with cash-flows in investment appraisal”

GOLDEN RULE www.antonioalcocer.com

“Cash-flow is a fact, net income

just an opinion”-Pablo Fernández IESE-

The net income amount is affected by accounting methods & a ssumptions made(i.e. depreciation & amortization that are not “real” ca sh inflows or outflows)Cash-flows are real money “entering” or “exiting” the com pany or project

www.antonioalcocer.com

P&L (*)

NET INCOME

-Cost of goods sold

GROSS PROFIT

-Selling, General & Administration-Other operating expenses

-Impairment

Net sales

-Taxes

EBITDA

-Depreciation & Amortization

EBIT

-Interests

INCOME BEFORE TAXES

(*) P&L=Profit & Loss account simplifiedP&L and Net Income are affected due to the accounting metho ds usedNet income is an opinion due to it depends on the calculatio nof the cost of goods sold, amortization method used & impai rmentNet income is not real cash-flow outlays of moneyDepreciation, amortization & impairment are not real c ash-flow outlays

HOW GOOD IS YOUR BUSINESSGENERATING “$” DUE THE OWNNATURE OF THE BUSINESS

FINANCING STRUCTURE

CORPORATE TAXES FRAMEWORK

www.antonioalcocer.com

“So nowI understandin investment appraisalwe useCASH-FLOWS”

www.antonioalcocer.com

But how manycash-flows exist?

www.antonioalcocer.com

Available “$” for the funds providers:_BANKS_SHAREHOLDERS

Free CASH-FLOW of the project (FCFF)=

www.antonioalcocer.com

Free CASH-FLOW of the project (FCFF)=

+EBIT X (1-t)

+D&A

+/-WORKING CAPITAL CHANGE

-CAPEX

FCFF= Real money generated by the project after accounti ng 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 curre nt assets changes, proceeds from long term assets sales, changes in long term assets; to be considered

www.antonioalcocer.com

Available “$” for theequity providers:_SHAREHOLDERS

Equity Free CASH-FLOW (FCFE)=

www.antonioalcocer.com

Equity Free CASH-FLOW (FCFE)=

+FCFF

+PROCEEDS NEW BANKING DEBT

- AMORTIZATION CURRENT DEBT

- INTERESTS OF DEBT * (1-t)

FCFE=Equity free cash-flow.Cash-flow available for shareholders after paying the bank ing funs providers.FCFE would be the money available for shareholdersT.S. REPUR= Treasury stock repurchase

- DIVIDENDS PAID & T.S. REPUR.

www.antonioalcocer.com

…and many others

www.antonioalcocer.com

NOW

WE ARE READY

FOR AN EXAMPLE!

www.antonioalcocer.com

Investment appraisal of a project with these free-cashflo ws

-$300m

t0=0

Diagram of the project free-cashflows (FCFF)Data in millions of US$Yearly data

t1=1 t2=2 t3=3

-$150m

+$175m

+$300m+$200m

+

-

www.antonioalcocer.com

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 disposethem

www.antonioalcocer.com

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

[BANK]“OK, have your funds, butat a 6.6% annual interest rat

Kd= 6.6%

www.antonioalcocer.com

[SHAREHOLDERS]

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

Ke= 20%

www.antonioalcocer.com

So, which amount/ratio should I ask forDon 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

WACC

www.antonioalcocer.com

OPTIMAL FINANCING STRUCTURE

[BANK]

[SHAREHOLDERS]

WACC

50% 60% 65%

50% 40% 35%

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%

Cheapest

www.antonioalcocer.com

So the $300 mill. + $150 mill.will be financedby a 65% banking debtby a 35% shareholders’ equitywith a WACC=10%

www.antonioalcocer.com

Profitability of the project = 50% in 3-years?

-$300m

t0=0

Diagram of the project free-cashflows (FCFF)Data in millions of US$Yearly data

t1=1 t2=2 t3=3

-$150m

+$175m

+$300m+$200m

%return= +300 + 175 + 200 - 300 - 150

450= 50%

www.antonioalcocer.com

Noooooo!!!!!!!!!

TIMEVALUE

OF MONEY

www.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

1) All FCFF are discounted to today & summed2) Using compound interest formula3) At a WACC rate

www.antonioalcocer.com

1. NET PRESENT VALUE=$0

Cash-flows generated exactly pay the cash-flows expectations requested by the banking & shareholders (funds providers)

[Undertake project]

www.antonioalcocer.com

1. NET PRESENT VALUE>$0

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

[Undertake project]

www.antonioalcocer.com

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

Cash-flows generated are not enoughto pay the cash-flows demmands by funds providers according to theirprofit expectations (=WACC)

www.antonioalcocer.com

1. Net present value = NPV – WACC=10%

-$300m

t0=0

Diagram 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

t1=1 t2=2 t3=3

-$150m

+$175m

+$300m+$200m

NPV = $131.2 = -300 ++300 -150

(1+10%)^1+

+175

(1+10%)^2

+200

(1+10%)^3+

Undertake project NPV>0

www.antonioalcocer.com

2. INTERNAL RATE OF RETURN (IRR)

=

Project’s CAGR

=_solve NPV=0

_get IRR

www.antonioalcocer.com

2. Internal Rate of Return (IRR) = 32.24% > WACC =10%

-$300m

t0=0

Diagram of the project free-cashflows (FCFF)Data in millions of US$Yearly dataIRR is obtained solving the equation

t1=1 t2=2 t3=3

-$150m

+$175m

+$300m+$200m

NPV = $0 = -300 ++300 -150

(1+IRR)^1+

+175

(1+IRR)^2

+200

(1+IRR)^3+

Undertake project

www.antonioalcocer.com

Solve non-linear equation

NPV=0

NPV<0

NPV>0

Fund providers unhappy

Fund providers exactly happy

Fund providers more than happyNPV excess for shareholders

1&2. Net present value summary

IRR<WACC

IRR=WACC

IRR>WACC

www.antonioalcocer.com

3. PAYBACK PERIOD

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

Years to recoverinvestment……you better pay

www.antonioalcocer.com

3. Payback period= 1.85 years

-$300m

t0=0

Payback period does not take into account time value of mone y, 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 > ne gative cumulative cashflows in year 1-2175/12=14.58-150/14.58=10.29 months = 10.29/12= 0.85 years

t1=1 t2=2 t3=3

-$150m

+$175m

+$300m+$200m

-300 -300+300-150 -300+300-150+175 -300+300-150+175+200

-300 -150 +25 +225

Cumulative

www.antonioalcocer.com

RE

We have learnt:Investment appraisal methodsProject free cashflowsWACCNPVIRRPayback

www.antonioalcocer.com

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

www.antonioalcocer.com