MANAGEMENT CERTIFICATE PROGRAM
Fisher College of BusinessThe Ohio State University
CORPORATE FINANCIAL ANALYSIS II
Bernadette A. Minton, PhD.
Part II
Financial Ratio Analysis
Capital Budgeting
Risk, the discount rate, and capital budgeting
Financial Ratio Analysis
Drivers of ValueAccounting Approach to
Shareholder Value
Financial Ratios – drivers of value
Ratio analysis is an excellent method for seeing sources of value and determining the overall financial condition of your business.
It puts the information from a financial statement into perspective, helping to spot financial patterns that may threaten the health of your company.
Ratios are also very useful for making comparisons between your business and other businesses in your industry.
For example, comparing ratios can indicate whether a business is turning inventory over too slowly.
This comparison provides a window into ways in which your business can improve its operations and increase shareholder wealth
Trend Analysis
Industry Analysis
Return on Equity (ROE)
Accounting Approach to Shareholder Value
How effectively does a firm use its equity capital to generate returns?
Equity
income Net ROE
AEP – ROE and Share Performance
AEP ROE and Year-End Share Price
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
RO
E
$0.00
$10.00
$20.00
$30.00
$40.00
$50.00
$60.00
ROE Stock Price
“Why does ROE change over time?”
The DuPont Identity “breaks down” sources of the firm’s return on shareholder equity
(Leverage)Turnover)X ssetMargin)x(A (Profit ROE
Equity
Assets x
Assets
Sales
Sales
Income Net ROE
ROE for AEP
Besides 2003, what is another benchmark to use? Industry ROE in 2004 = 0.1026
2002 2003 2004Net Profit Margin -0.0349 0.0082 0.0779Asset Turnover 0.41841 0.39585 0.40553Financial Leverage 4.81911 4.63062 4.04186ROE -7.05% 1.50% 12.77%
Other Common Profitability or Return Ratios
ROA = Return on Assets
ROIC = Return on Invested Capital
Sometimes net operating profit after tax (NOPAT) is used instead of net income
Assets Total
expenseInterest IncomeNet ROA
Stock Preferred Equity Debt Capital Total
Capital Total
Dividends- IncomeNet ROIC
Long-Term Leverage (i.e., Debt) Ratios
To what extent does the firm use debt to finance its assets?
How able is the firm to service its debt?
Short-Term Liquidity Ratios
How effectively can the firm meet its cash obligations as they come due?
Asset Efficiency Ratios
How efficiently does the firm manage its operating assets?
Profitability Ratios
How effectively does the firm manage expenses, returns to investors and distributions from earnings?
Other Groups of Financial Ratios
Selected Ratios for AEP – FYE 2007
Ratio AEP Industry PeersLeverage RatiosLong-term debt/(Long-term debt +Equity) 0.6139 0.5584LT Debt/Equity 1.5899 1.5274Interest Coverage Ratio 4.2489 5.0297
Short-term Liquidity RatiosCurrent Ratio 0.5861 0.9202Quick Ratio 0.3188 0.5328
Efficiency RatiosInventory Turnover 10.0755 17.2597Days Cost of Goods Sold in Inventory 36.2264 27.3533Asset Turnover 0.3415 0.4315
Profitability & Return MeasuresNet Profit Margin 0.1504 0.1503ROA 0.0514 0.0594ROE 0.1121 0.1616ROIC 0.0188 0.0393
Market Value Ratios for Public Companies
How much are investors willing to pay for a dollar of the firm’s current earnings?
What is the ratio of the market value of the firm's investments to their historical costs?
AEP and Selected Competitors
American Electric Power Co. Inc.
Allegheny Energy Inc. Progress Energy Inc.
Dominion Resources Inc.
(Virginia) Entergy Corp. FPL Group Inc.Current Share Price $26.51 $28.55 $35.45 $31.82 $73.96 $56.93 Net Profit Margin 9.60% 11.70% 9.10% 11.30% 9.50% 10.00%Forward P/E 9.3 11.9 11.8 9.7 10.7 13.5Price/Book 1 1.7 1.8 1.8 1.7 2ROE 12.80% 14.30% 8.90% 18.90% 16.10% 14.70%ROA 3.20% 3.80% 2.70% 4.50% 3.50% 3.70%
Date: 5/7/09Source: www.smartmoney.com
P/E Ratios and Valuation
Using P/E ratios and Earnings per share (EPS) estimates to forecast stock prices14-May-09
Company AEP
Current Price $26.03Current P/E 9.13Current EPS 2.88
EPS estimatesFYDec09 EPS Projected Price = (P/E)*(EPS estimate)Mean 2.86 $26.11
FYDec10Mean 3.06 $27.94
Forecast EPS growth for FY09P/E FY08 EPS Price Upside
15% EPS growth 9.13 3.31 30.24$ 16.17%5% EPS growth 9.13 3.02 27.61$ 6.07% -10% EPS growth 9.13 2.59 23.66$ -9.09%
Economic Value Added (EVA)
Economic Value Added (EVA) Represents a firm’s net dollar profit after deducting the cost
of the capital used to finance the firm’s assets. Captures the economic value that managers actually create
for the firm’s shareholders.
Basic EVA calculation:
EVA represents a better measure of performance than accounting profit, which ignores the cost of capital.
EVA is copyrighted by Stern-Stewart, Inc., and is used with permission.
capital) of (Cost profit) operating tax-(After EVA
ROE and EVAAccouting Measures of Company Performance, 2006
Cost of Equity ROE EVAGoogle 12.9% 55.34% 2,243.98$ Goldman Sachs 10.8% 31.00% 6,181.88$ Harley Davidson 8.3% 26.89% 780.48$ Coca-Cola 6.3% 24.22% 3,371.72$ Colgate-Palmolive 6.9% 20.69% 1,255.62$ Anhueser-Busch 6.0% 14.53% 1,332.50$ GE 7.3% 13.92% 8,233.41$ FedEx 7.5% 7.91% 146.85$ Xerox 7.3% 5.35% (509.11)$ Time Warner 8.0% 3.73% (5,954.80)$ Wendy's International 7.1% 2.83% (147.66)$ GM 6.9% -0.02% (6,952.09)$
Source: Brealey, Myers and Marcus, 2009
Financial Ratios on the Web: AEP
Source: http: money.cnn.com
Mkt. Cap. (Mil) $ 12,624.63 Yield % 6.19 Gross Margin (TTM) % 6.19Shares Out (Mil) 476.76 Annual Dividend 1.64 Operating Margin (TTM) % 28.3
Payout Ratio (TTM) % 48 Profit Margin (TTM) % 9.6
Price/Earnings (TTM) 7.7 Earnings (TTM) $ 3.42 Return on Equity (TTM) 12.9Price/Sales (TTM) 0.87 Sales (TTM) $ 30.29 Return on Assets (TTM) 3.1Price/Book (MRQ) $ 0.99 Book Value (MRQ) $ 26.33 Return on Investment (TTM) 5.3Price/Cash Flow (TTM) $
3.6 Cash Flow (TTM) $ 7.26
Quick Ratio (MRQ) 0.41 LT Debt/Equity (MRQ) 1.45Current Ratio (MRQ) 0.6
2008 Next Qtr
Revenue $ 14.4 B Mean Estimate 0.57 0.87 Buy 7Total Net Income $ 1.4 B High Estimates 0.63 0.96 Overweight 6Earnings Per Share $3.42 Low Estimates 0.42 0.8 Hold 5EBITDA $ 4.1 B # of Estimates 7 7 Underweight 0Long Term Debt $ 15.5 B Sell 0
Mean OVERWEIGHT
Current Analyst RatingsPer-Share EstimatesThis Qtr
Financial Strength
Mil = Millions MRQ = Most Recent Quarter TTM = Trailing Twelve MonthsFinancial Snapshot
Share Related Items Dividend Information Profitability
Valuation Ratios Per Share Data Management Effectiveness
Using Financial Ratio Analysis Choosing a benchmark for comparison:
Reference time periods Comparable firms
Reconciling differences in accounting practices(international comparisons)
Dealing with extraordinary (one-time) events(corporate restructuring)
Using Financial Ratio Analysis
Dealing with seasonal variation in operations
Evaluating privately-owned companies
Choosing good benchmarks for conglomerates (In which industry does a firm like GE belong?)
Ratio analysis requires a lot of judgment. Ratio analysis has little underlying financial theory.
Capital Budgeting
Determining how to allocate capital on new investment
Capital Budgeting
Capital Budgeting as a Management Practice Estimation of Cash Flow Evaluation Techniques
Net Present Value (NPV Rule) Internal Rate of Return Payback
Risk and Capital Budgeting Case
Capital Budgeting as a Management Process
Development of a strategic plan
Generation of potential investment opportunities
Estimation of a project’s cash flows
Acceptance or rejection
Project post-audit
Investment Projects and Investment Criteria
Investment projects often are defined by: the industry in which a firm operates the mission statement of a non-profit firm.
Managers should use criteria consistent with increasing shareholder wealth.
There are trade-offs among different criteria used by companies
Net Present Value Formula
Net Present Value (NPV) The difference between the PV of a project’s future
after-tax cash flows and the project’s initial cost.
General formula for NPV:
where Ci is a project’s ith cash flow (may be positive or negative) N is the length of the project in time periods R is the project’s required rate of return
Investment R)(1
C...
R)(1
C
R)(1
C NPV
NN
221
Net Present Value Investment Rule Net Present Value Rule
Accept all projects with a positive net present value. Reject all other projects.
WHY?
The goal of financial managers is to increase the wealth of shareholders. Managers should accept all projects worth more
than their cost. Only projects with a positive NPV “add value” to
shareholder wealth.
Incremental Cash Flows Only
Include all indirect effects
Forget sunk costs
Include opportunity costs
Remember the investment in working capital
Beware of allocated overhead costs
Discount after-tax cash flows !!!
Incremental Cash Flow
Cash Flow with Project
Cash Flow without Project= –
Estimation of Cash Flow Simplified
Components of Net Cash Flow
REVENUE
– Operating expenses (cash expenses only)
– Income taxes paid
= Net cash flow from operations
– Net working capital investment
– Net capital investment
= NET CASH FLOW
Net cash flow is the project’s total after-tax cash flow.
For NPV, this net cash flow is discounted using a discount rate that is project specific
Investment Criteria
Analyzing the after-tax cash flow
Investment Criteria
Used to analyze the after-tax net cash flows
Want a criterion that: Is consistent with maximizing shareholder value
Recognizes the timing of the cash flows
Recognizes the risk of the cash flows
Capital Budgeting Problem
Your company is considering a 3-year investment project to develop a new business process.
The project’s initial capital cost is $395,000, which will cover space renovation and new equipment.
During its 3-year run, the project is forecasted to: generate annual cash revenue of $375,000. incur annual cash operating expenses of $190,000. earn an annual cash profit of $185,000.
If management requires this project to earn a 10% annual rate of return on invested funds, should the project be launched?
Investment Project Pro-Forma
Today Year 1 Year 2 Year 3
Capital Cost (395,000)
Revenue 375,000 375,000 375,000
Operating Expenses
190,000 190,000 190,000
Net Profit 185,000 185,000 185,000
Net Cash Flow (395,000) 185,000 185,000 185,000
NPV Investment Criterion
The PV of the future cash flows of the project are:
If we owe the providers of funds $395,000,then once we pay this final expense, we still will have $65,068:
NPV = 460,068 – 395,000 = 65,068
Should you accept the project?
068,460)10.1(
11
0.10
185,000PV
3
The Internal Rate of Return (IRR) Criterion
The IRR is the discount rate that makes the PV of the future cash flows of an investment equal to its initial cost.
Thus, the IRR is the discount rate that gives a project an NPV of zero.
For projects with “conventional” cash flows, Accept the project if the IRR > Cost of Capital (or hurdle rate)
Internal Rate of Return Criterion
To determine the IRR of the capital budgeting project, you will need to solve the following expression:
32 IRR) (1
185,000
IRR) (1
185,000
IRR) (1
185,000 395,000- 0
Internal Rate of Return
Solving the formula for IRR requires either Excel or a financial calculator. The Excel approach:
The investment project’s IRR is 19.14%. How should the 19.14% IRR be interpreted?
Calculating IRR by using a spreadsheet
Year Cash Flow Formula0 (395,000.00) IRR = 19.14% =IRR(B3:B7)1 185,000.00 2 185,000.00 3 185,000.00
Conference Planning ExampleA Twist on IRR
A non-profit is organizing a conference. All conference fees are collected today (t = 0).
Total Fees collected = $20,000
All expenses for the conference will be paid on the conference date, six months from today.
Expected total expenses = $20,225
The six-month required rate of return for the project is 3.25%.
Should the non-profit proceed with the conference?
Conference Planning Example
The IRR is 1.125% on a six-month basis.
What is the NPV of the project at 3.25%?
$20,000
-$20,225
IRR) (1
20,225 - 20,000 0
IRR revisited
Costs up-front (i.e. negative cash flow), followed by positive cash flows Accept Project if IRR > Cost of Capital
Costs at the end of the project only (i.e. negative cash flow in last period), preceded by positive cash flows Accept Project if IRR < Cost of Capital
Similarities between NPV and IRR
Both are Discounted cash flow (DCF)
techniques that focus on the amount and
timing of a project’s cash flows.
Both can accommodate differences in risk by
adjusting the project’s required rate of return.
Both give the same accept-reject decision for
independent projects.
Differences between NPV and IRR
NPV is an absolute measure of project worth.
NPV assumes the cash
flows are reinvested at the required rate of return
The NPV is unique for a given required rate of return.
IRR measures the return per dollar invested.
IRR assumes the cash flows are reinvested at the IRR
With an unconventional cash flow pattern, there may be multiple IRRs
Payback Investment Rule
$185,000 $185,000
– $395,000 0 1 2
We invest $395,000 at the start of the project (initial investment), and we earn the cash flows shown below in each year
Payback Rule: Accept all projects that pay back prior to cutoff
$185,000
3
Project Time Period (years)
Payback Rule
Time Cash Flow Accumulated Cash Flow1 185,000.00$ $185,000.002 185,000.00$ $370,000.003 185,000.00$ $555,000.00
After two years need to accumulate 25,000.00$
Payback Period is between 2 and 3 years
Payback period= 2.1351 = 395,000/185,000
Comparison of Payback and NPV
Limitations of the Payback Rule Ignores the time value of money Ignores cash flows beyond the payback period
No connection between the maximum acceptable payback period and shareholder required rates of return.
The payback rule is popular among companies. Often used when the capital investment is small, and
when the merits of a project are so obvious that more formal analysis is really unnecessary.
Capital Budgeting in Practice
Most large firms use either IRR and/or NPV for making decisions
IRR appears to be more popular than NPV
Payback is used heavily as a secondary method
Issues to Monitor in Capital Budgeting
Ensuring consistent financial forecasts (methodology and assumptions) across a firm’s operating divisions
Eliminating conflicts of interest
Reducing forecast bias
Avoiding costs not properly attributable to a project
Using appropriate investment criteria (NPV)
Risk and Capital Budgeting
The Cost of Capital
Consider our 3-year project from before. NPV = 460,068 – 395,000 = 65,068
The discount rate for the 3-year project is 10%.
What do we mean by the statement, “Management requires a 10% return on invested funds?”
Suppose the $395,000 initial investment came from the following sources:
$200,000 provided by creditors (bond proceeds) $195,000 provided by shareholders (stock proceeds)
Do bondholders and shareholders require anything in return for the use of their money?
Cost of Capital (WACC)
Bondholders require interest payments and the repayment of principal.
Shareholders require a return on their invested funds, and further, they hope managers won’t lose their money.
The Firm’s Cost of Capital, WACC:
where D = market value of the debt, E = market value of equity; V = value of the firm = D + E; RD = rate of return required by bondholders;
RE = rate of return required by the equity holders.
ED R
V
E R TAXRate)(1
V
D WACC
Cost of Debt Capital (RD)
If we issue 3-year bonds to finance the project, what sort of return will bondholders require?
Yield-to-maturity (YTM) on newly issued bonds with comparable risk same credit quality and same maturity.
Suppose the market yield-to-maturity on comparable debt is 11.23%.
The Cost of Equity Capital (RE)
If investors buy shares of common stock to finance the project, what sort of return will they require?
One model to estimate the required return on equity (RE) is the Capital Asset Pricing model (CAPM):
Return = Risk-free rate + company beta x (Market risk premium) Beta is a measure of the stock’s market risk Market risk premium = return on market – risk-free rate
Suppose the company’s beta is 1.20, the risk-free rate is 2%, and the market risk premium is 9%
Beta = 1.20 => more market risk than the market portfolio ie. if the market goes up 10%, stock goes up about 12%
RE = 12.8% = 0.02 + 1.2x0.09
The Firm’s Cost of Capital
What is the after-tax return on the $395,000 portfolio?
Amount of equity $ 195,000
Amount of debt 200,000
Bond required return 11.23%
Stock required return 12.8%
Firm’s tax rate 35.00%
The after-tax rate of return on the portfolio of securities:
The 10% figure is the project’s cost of capital (what the project MUST earn to break even)
10.0% 000,200000,195
(0.128) ,000195 (0.1123))035.01(000,200
The Cost of Capital If a project earns its cost of capital:
All operating expenses are paid. Bondholders get the required YTM and the
repayment of their bond principal (amount originally loaned).
Shareholders get the required CAPM return and the “best efforts” of management to preserve their principal.
If a project fails to earn its cost of capital, the deficit may be covered by other projects in the company. BUT, the negative NPV represents lost shareholder
value.
When is it okay to use the firm’s WACC?
Proposed investment project is similar to the overall business activities of the firm
Project is financed with essentially the same capital structure (mix of debt and equity) as the firm.
To the extent a project differs from the firm’s typical project profile, the firm’s cost of capital may be a less suitable rate. What do you do?
Using CAPM to estimate a discount rate
If you can estimate/collect the project’s beta, you can use CAPM:
Riskfree rate: Return on Treasury security Beta: ValueLine, Morningstar Market Risk premium
Return on S&P 500 – Return on Treasury security
rate Riskfree - market the on Return premium Risk Market
where
Premium) Risk (MarketBeta Project rate Riskfree R
Estimating Cost of Capital for Small Businesses or Non-Profits
Recall, the cost of capital equals the opportunity cost of capital
Candidates: Banks loan rates Risk-free rate for riskless projects Small business loan rate Use beta from comparable publicly traded company.
Case: PGA New Venture
The PGA New Venture Problem
The PGA Corporation plans to launch a set of commemorative golf club covers. Expected revenues from the project are shown below. Expenses will run 25% of revenues, with working capital required each year set to 15% of revenues in the following year.
The project has the following expected revenues: Year 1: $293,000 Year 2: $367,000 Year 3: $448,000 Year 4: $507,000 Year 5: $428,000
The project will be discontinued at the end of Year 5.
A new building must be acquired at the start of the project at a total cost of $936,800. The facility is to be depreciated straight-line over five years to a salvage value of zero, but management has agreed to sell it for $163,000 at the end of the project.
If PGA’s cost of capital is 14.75%, and its tax rate is 35%, what is the project’s NPV? Should the company launch the venture?
Components of a Project Pro-Forma
The pro-forma organizes a project’s financial information.
Project start-up Strategic assets (tangible and intangible) Working capital requirements
Project operation; On-going Cash flow from operations and net cash flow Adjustments to project assets and working capital
Project completion or shut-down Cash flow from the recovery of working capital Cash flow from the sale or transfer of project assets
Cash Flows in a Typical Project
Adopted from Berk, DeMarzo, and Harford (2008)
Start-Up On-Going Shut-Down
Purchase of Equipment Incremental Revenues Sale of Equipment(Net of taxes)
Increase in Net Working Capital Incremental Costs(Increases in inventories, raw materials, etc) Decrease in NWC
Taxes (Decrease in inventories, raw materials,etc.)Initial Development Costs
Change in NWC Shut-Down Costs(Change in inventories, accounts
receivables and payable)
Sample SpreadsheetWACC = 0.1475
YEARAccount Today 1 2 3 4 5Capital investment
Net Working CapitalChange in NWC
RevenuesExpenses (25% of revenues)DepreciationPre-tax income
Income taxes @ 35%Net cash flow from operations
CF from factory sale
Net Cash flowPV(Net Cash flow) @14.75%NPV at 14.75% =
Project Start-Up
A new building must be acquired at the start of the project at a total cost of $936,800.
The facility is to be depreciated straight-line over five years to a salvage value of zero, but management has agreed to sell it for $163,000 at the end of the project.
Net working capital required each year equals 15% of revenues in the following year
So, at t=0, initial working capital is 15% of the first year’s sales.
First-year’s sales = $293,000
0.15x293,000
Organizing the Information
Net working capital 43,950 = 0.15x293,000
Change in NWC = 43,950 (an increase; a cash outflow from the firm)
Capital investment = 936,800 (a cash outflow from the firm)
WACC = 0.1475
Account Today 1Capital investment 936,800.00
Net Working Capital 43,950.00Change in NWC 43,950.00
Revenues 293,000
Net Working Capital Investment
Investment in inventories and receivables:
Should be included
in incremental cash flows.
Common problems in project development: Neglecting working capital
Forgetting that working capital requirements can change over the life of a project
Forgetting that the working capital investment is recovered by the end of the project
Net Working Capital Investment
Consider the capital budgeting problem
Today Year 1Year 2
Revenue 293,000367,000
Net Working capital
(15% of next year’s revenues) 43,950 55,050
Change in NWC 43,950 inc 11,100 incThe working capital investment must be in place at the
start of the year for which the funds are required.
Working Capital Investment
Notice that a positive number represents an increase in the working capital account
Represents a use of cash to the firm
WACC = 0.1475YEAR
Account Today 1 2 3 4 5Capital investment 936,800.00
Net Working Capital 43,950.00 55,050.00 67,200.00 76,050.00 64,200.00 0.00Change in NWC 43,950.00 11,100.00 12,150.00 8,850.00 -11,850.00 -64,200.00
Revenues 293,000 367,000 448,000 507,000 428,000
On-Going Part of Project
Changes in NWC Revenues Expenses = 25% of revenues Taxes
Need to calculate pre-tax income. Thus, need to calculate depreciation
On-Going Part of Project
Need to calculate depreciation and pre-tax income in order to calculate taxes.
WACC = 0.1475YEAR
Account Today 1 2 3 4 5Capital investment 936,800.00
Net Working Capital 43,950.00 55,050.00 67,200.00 76,050.00 64,200.00 0.00Change in NWC 43,950.00 11,100.00 12,150.00 8,850.00 -11,850.00 -64,200.00
Revenues 293,000 367,000 448,000 507,000 428,000Expenses (25% of revenues) 73,250 91,750 112,000 126,750 107,000
Depreciation
Recall, from accounting that depreciation is not a cash expense but it does affect net profits and therefore taxes paid (which is a cash item).
Straight-line depreciation Constant depreciation for each year of the asset’s accounting
life Take the cost of the asset and divided it by the number of
years that it is used. Modified accelerated cost recovery (MACRS)
Depreciation method that allows for higher tax deductions in early years and lower deductions in later years.
Places assets into one of six classes, each of which has an assumed life.
MACRS, Examples of Recovery Classes
Year(s) 3-Year 5-Year 7-Year 1 33.33 20.00 14.29 2 44.45 32.00 24.49 3 14.81 19.20 17.49 4 7.41 11.52 12.49 5 11.52 8.93 6 5.76 8.93 7 8.93 8 4.45
Recovery Class Period
• Equipment is assigned a recovery class and then depreciated.
• The half-year convention (see 5-year schedule):
Assume the asset was purchased at the mid-point of the first year; provides one-half depreciation the 1st year and the 6th year.
Depreciation
A new building must be acquired at the start of the project at a total cost of $936,800.
The facility is to be depreciated straight-line over five years to a salvage value of zero.
Depreciation each year: $936,800/5 = $187,360.00
YEARAccount Today 1 2 3 4 5Capital investment 936,800.00
Working Capital 43,950.00 55,050.00 67,200.00 76,050.00 64,200.00 0.00Change in working capital 43,950.00 11,100.00 12,150.00 8,850.00 -11,850.00 -64,200.00
Revenues 293,000 367,000 448,000 507,000 428,000Expenses (25% of revenues) 73,250 91,750 112,000 126,750 107,000Depreciation 187,360 187,360 187,360 187,360 187,360
How much do we pay in taxes?
Need to calculate pre-tax incomePre-tax income = Revenues – Op. expenses – Depreciation
Taxes paid = (tax rate)x(pre-tax income) Tax rate = 35% in the problem
YEARAccount Today 1 2 3 4 5Revenues 293,000 367,000 448,000 507,000 428,000Expenses (25% of revenues) 73,250 91,750 112,000 126,750 107,000Depreciation 187,360 187,360 187,360 187,360 187,360Pre-tax income 32,390 87,890 148,640 192,890 133,640
Income taxes @ 35% 11,337 30,762 52,024 67,512 46,774
Completion of the Project
Sale of the building for $165,000 Recover all Net working capital
NWC in year 5 = 15% of year 6 revenues NWC in year 5 = 0.15x0.00 = 0.00 Recover all NWC means drive the NWC account
balance to zero.
Market value of factory 163,000
Book value of factory 0
Taxable gain on factory sale 163,000
Taxes on taxable gain @ 35% 57,050
Cash flow from factory sale 105,950
Cash Flow from Asset Sale in Year 5
The building is to be depreciated straight-line over five years to a salvage value of zero, but management has agreed to sell it for $163,000 at the end of the project.
Project components
WACC = 0.1475YEAR
Account Today 1 2 3 4 5Capital investment 936,800.00
Net Working Capital 43,950.00 55,050.00 67,200.00 76,050.00 64,200.00 0.00Change in NWC 43,950.00 11,100.00 12,150.00 8,850.00 -11,850.00 -64,200.00
Revenues 293,000 367,000 448,000 507,000 428,000Expenses (25% of revenues) 73,250 91,750 112,000 126,750 107,000Depreciation 187,360 187,360 187,360 187,360 187,360Pre-tax income 32,390 87,890 148,640 192,890 133,640
Income taxes @ 35% 11,337 30,762 52,024 67,512 46,774Net cash flow from operations
CF from factory sale 105,950
Components of Net Cash Flow
REVENUE
– Operating expenses (cash expenses only)
– Income taxes paid
= Net cash flow from operations
– Net working capital investment
(excess of new investment over recovered funds)
– Net capital investment
(excess of purchase amounts over sale proceeds)
= NET CASH FLOW
Net cash flow is the project’s total after-tax cash flow.
Net Cash Flows from Operations
Consider year 2
Revenue 367,000
– Operating expenses 91,750
– Income taxes paid 30,762
Net cash flows from operation= 244,488
YEARAccount Today 1 2 3 4 5Revenues 293,000 367,000 448,000 507,000 428,000Expenses (25% of revenues) 73,250 91,750 112,000 126,750 107,000Depreciation 187,360 187,360 187,360 187,360 187,360Pre-tax income 32,390 87,890 148,640 192,890 133,640
Income taxes @ 35% 11,337 30,762 52,024 67,512 46,774Net cash flow from operations 208,414 244,488 283,976 312,739 274,226
Net Cash Flow for Year 2
Revenue 367,000
– Operating expenses 91,750
– Income taxes paid 30,762
= Net cash flow from operations 244,488
– Change in net working capital (NWC) 12,150
– Net capital investment 0
= NET CASH FLOW 232,338
The following table shows the relation between project revenue in Year 2 and project net cash flow.
Putting it all together
NPV @ 14.75% = ($39,710) and IRR = 13.25% Do not launch the venture.
WACC = 0.1475YEAR
Account Today 1 2 3 4 5Capital investment 936,800.00
Net Working Capital 43,950.00 55,050.00 67,200.00 76,050.00 64,200.00 0.00Change in NWC 43,950.00 11,100.00 12,150.00 8,850.00 -11,850.00 -64,200.00
Revenues 293,000 367,000 448,000 507,000 428,000Expenses (25% of revenues) 73,250 91,750 112,000 126,750 107,000Depreciation 187,360 187,360 187,360 187,360 187,360Pre-tax income 32,390 87,890 148,640 192,890 133,640
Income taxes @ 35% 11,337 30,762 52,024 67,512 46,774Net cash flow from operations 208,414 244,488 283,976 312,739 274,226
CF from factory sale 105,950
Net Cash flow -980,750.00 197,313.50 232,338.00 275,126.00 324,588.50 444,376.00PV(Net Cash flow) @14.75% -980,750 171,951 176,447 182,085 187,207 223,351NPV at 14.75% = -39,710IRR 13.25%
Handling Project Uncertainty
Sensitivity Analysis Analyzing the effects of changes in project parameters
(e.g., investments and costs) on project profitability
Scenario Analysis Evaluating project performance and profitability under
alternative combinations of assumptions.
Simulation Analysis Estimating the probability of different outcomes for an
investment project.
PGA New Venture AnalysisDid You Estimate the Risk Correctly?
Suppose you over-estimated the risk? Choose a lower discount rate. Suppose R = 12%. Then the NPV = $34,902.
Launch the venture
Suppose you under-estimated the risk? Choose a higher discount rate. Suppose R = 16%. Then the NPV = -$70,889.
Do not launch the venture