Electronic copy available at: http://ssrn.

com/abstract=2028640
* Bartomiej Cegowski, assistant professors at the Department of Finance at Kozminski University in
Warsaw, ceglos@kozminski.edu.pl
** Pawe Mielcarz, assistant professors at the Department of Finance at Kozminski University in
Warsaw, pmielcarz@kozminski.edu.pl


Application of break-even revenue concept in assessment of
investments generating time-limited free cash flows



Bartomiej Cegowski*
Pawe Mielcarz**



























Electronic copy available at: http://ssrn.com/abstract=2028640
2

1. Introduction
The statement that good investment decisions are extremely important for the success of
a company in the long run (Bennouna et al., 2010) seems to be especially valid in the
time of crisis which proves to be really effective in exposing the consequences of bad
investment decisions. This statement also brings the issue of evaluation and selection of
investment projects into the spotlight of management process. Projects evaluation is
associated with the process of forecasting the free flows generated by the investment. It
is a time-consuming activity, requiring performance of a number of analyses concerning
revenues, expenses, working capital, capital expenditure and sources of financing. It
may appear that forecasting expected revenues is an operation particularly exposed to
risk and manipulation. Therefore, instead of spending too much time for prediction of
future demand and for formulating market strategies, it is worth to look for a tool which
is able to indicate the level of revenue necessary for achieving the expected rate of
return on the invested capital.
The aim of the article is to present a new method of investment projects evaluation,
which facilitates the process of value creation analysis and generates an easily-
interpretable information for non-experts of financial analysis. Some limited versions of
the approach have been already presented to some extent in reference books (Nita 2007;
Cegowski, Mielcarz, 2012).
1
However, this article provides a version extended by new
elements and formalized in the form of closed formulas facilitating the methods
application. The presented solution conforms with the rules of value based management.
Its use in the preliminary phase of the analysis allows calculation of minimum revenue
which is necessary to generate the required rate of return in the specified time horizon.
Thus this method helps to recognise projects which do not hold out the prospect for
creating a positive net present value. The information about the minimum revenue is
easy to present after small modifications in a more approachable and understandable
way to decision makers, e.g. as the number of customers per day, daily sales, minimum
occupancy rate or market share, necessary to achieve the expected rate of return on the
invested capital.

2. Value based management analytical tools

1
Under the name of Value creation threshold or Financial Break-Even Point
3

There are numbers of tools created as part of theory and practice, which aim is to
support managements decision-making processes. Taking into account their purposes,
two main groups of analytical tools can be singled out. The first consists of financial
measures used in monitoring effectiveness of value based management (Merchant;
2006). This group includes economic value added (EVA of Stern Stewart & Co.), cash
flow return on investment (CFROI of Value Associates), total business return (TBR of
Boston Consulting Group), economic profit (EP of McKinsey & Co.) and shareholder
value added (SVA of LEK/Alcar). Considering the frequency of appearance in reference
books, the interest among researchers, as well as the commonness of corporate
application, the economic value added can be recognized as the most popular tool
2
.
The second group consists of tools supporting the evaluation of investment decisions.
The majority of studies shows that in corporate practice, the tools which are used most
often base on the concept of net present value (Jog and Srivastava: 1995, Graham and
Harvey 2001, Ryan and Ryan, 2002). Yet, despite the dominance of discounting
methods, the method of payback period is also popular (PP Payback Period; Graham,
Harvey 2001). Studies by K. Bennouna, G. Meredith , T. Marchant reveal that almost as
many as 79% of the surveyed companies still use the tool (Bennouna et al., 2010). It
seems that this method is so popular mainly due to its simplicity and easiness of
interpretation.
The clarity of a method itself, as well as acceptance among managers are, in fact,
particularly significant issues. The decision makers not only have to know the method
of calculation of a given measure, but they should most of all be able to understand the
results obtained (Merchant 2006). Without the correct understanding of the essence of
the tool and the results of the performed analyses, making a right investment decision is
much hindered.

3. Calculation of break-even revenue for projects generating perpetual cash flow
3

Break-even is the sales (in quantity or value) where costs of s company or a project are
covered by its revenue. The simplest way to calculate break-even revenue is by using
the following formula:

2
In the 90s of the 20
th
century, Stern Stewart implemented management systems based on EVA in over
700 companies (see: www.sternstewart.com/?content=history&p=1990s)
3
This part of the article discusses the concept of value creation break even, described in reference books
(Nita, 2007). The tools developed and described by the authors in part four of the article base on the
assumptions of value creation break even, thus the convention of discussing new solution in reference to
the already known ones has been adopted.
4


BEP
w
=
FC
t
+A
t
H
%
(1)
where: BEP
w
value break-even point,
FC
t
fixed costs without amortization, incurred in the time period t,
A
t
amortization costs incurred in the time period t,
M
%
gross margin in percents, calculated as the difference between sales and
variable costs, referred to the value of sales.
The revenue guaranteeing the achievement of the required operational profit is
calculated on the basis of formula 2:

BEP
w
=
FC
t
+A
t
+Z
t
H
%
(2)

where: Z
t
the value of the expected operational profit in period t

Calculation of the break-even according to formulas 1 and 2 does not lead to
information useful for the evaluation of investment projects, for it omits the costs and
value of the employed capital necessary to finance the fixed assets and net working
capital. These areas are included in the concept of economic profit, described often as
economic value added (EVA) (Makowiak 2009). Its value can be calculated based on
the following formula:
[ ]
1
=
t t t
CI WACC NOPAT EVA (3)

where: NOPAT
t
net operating profit after tax in the period t,
WACC
t
- weighted average cost of capital,
CI
t-1
capital invested; capital employed in financing fixed assets and working
capital in period t-1
Net operating profit after tax value is calculated using formula 4:

N0PAI = (P H%FC A) (1 I) (4)
where: P revenue,
T tax rate.

5

According to the fundamental assumption of EVA concept, a company does not
generate, nor does it lose value for its shareholders in a given period in a situation when
the achieved EVA equals 0. Assuming in the case of formula 3 that in a given period the
EVA equals 0 and substituting the profit (Z) with the value of NOPAT, the following
formula can be presented as:

(5)


where: BEP
s
- value of break-even revenue ensuring EVA at 0 level
Formula 5, allowing for the calculation of break-even revenue, has already been
presented in reference books (Nita 2007). In practice, this formula lets defining the
value of revenue ensuring the achievement of zero NPV from investment projects with
the assumption that the free cash flow generated by the projects will be fixed and
perpetual. This fact can be arrived at by analyzing one of the formulas for the
calculation of NPV, which assumes the use of future EVAs for this purpose:
NPI =
EIA
t
(1 +wACC)
t

t=1
(6)
Taking into account that formula 5 allows for determining of the revenue resulting in a
zero EVA, it stems from formula 6 that this revenue also allows for the achievement of
a zero NPV from a project in the conditions of fixed perpetual EVA.
To increase value of a company, NPV positive project should be implemented. A zero-
level NPV project means that the project allows for the achievement of rate of return
expected by the investors, but it does not increase value of the company. In the
conditions of full financial market efficiency, taking a decision on investing in a zero
NPV project will not affect the change of value of the entity running the project. Thus,
it is a break-even value with which the implementation of a project is neutral from the
owners perspective.
The financial literature (Fernandez 2007) points out that there are nine techniques of
calculation of free cash flow and discount rates, which when applied properly
should give an identical net present value from a project. These methods include both
the calculation basing on future economic values added (formula 6), as well as the
future free cash flow for firms. One disadvantage of NPV calculation basing on EVA
( )
( ) T M
WACC CI T A FC
BEP
t t
S
t

+ +
=

1
) 1 (
%
1
6

technique is the relatively low recognisability of such approach in the environment of
analysts and decision makers (Ryan and Ryan, 2002). The best known and most used
approach in terms of the process of evaluation of investment projects is calculation
based on FCFF formula. The NPV calculation formulas for the projects generating free
cash flow for firms in the required time period are as follows:

NPI = CI
t-1
+
FCFF
t
(1 +wACC)
t
n
t=1
(7)

where: FCFF
t
= N0PAI
t
+A
t
CI
t

CI = capital investments (I) + working capital investments (WCI)


4. Break-even revenue for projects generating time-limited free cash flow
The concept of break-even revenue for the projects generating time-limited free cash
flow, which will allow for the achievement of the required rate of return within a given
period the NPV equalling zero is a combination of four tools used for financial
analysis. These include:
break-even,
economic profit (economic value added),
discounted payback period,
present annuity value.
The formula for the present value of annuity is as follows:

PI = PHI
1 (1 +r)
-n
r

(8)
where: PV present value
PMT the amount of each payment
r interest rate in percent, updating annuity payments
n number of periods in annuity

In order to determine the minimum yearly values of EVA, ensuring a zero NPV in the
required time period, it is to be assumed that:
1. PV equals the value of the capital invested in the implementation of the project
(PV = CI)
7

2. r equals the value of the weighted average cost of capital, the expected rate of
return on the investment project (r = WACC)
3. n is the number of periods of the project
4. PMT equals the yearly value of EVAs necessary to be achieved in the required
time (n), so that the present value of EVA becomes equal with the value of the
capital invested in the implementation of the project (CI)
Next, we have to reformulate formula 8 with regard to EVA (PMT) and substitute the Z
from formula 2 with the obtained formula. By means of appropriate reformulations we
arrive at formula 9 which allows us to calculate the value of revenue (BEP
E
), with
which in a given period the expenditures for the implementation of investments and the
present value of the related arising cash flow are equal. In addition, this model is
characterized by the following assumptions:
1. residual value after the project is finished equals 0
2. there is a reinvestment of the amount equal to the costs of amortization
incurred in subsequent years.
BEP
L
=
FC +A
H
%
+
CI
wACC
1 (1 +wACC)
-n
(1 I) H
%

(9)
where: BEP
E
break-even value of revenue ensuring the achievement of a zero NPV
for the project generating cash flow in a specified time horizon

Considering the fact that residual value may be different than zero is associated with the
necessity to decrease the value of the capital invested by the present value of expected
residual value. An appropriate correction is included in formula 10:
BEP
L
=
FC +A
H
%
+
_CI
RI
(1 +wACC)
n
]
wACC
1 (1 +wACC)
-n
(1 I) H
%

(10)

The elimination of the assumption of necessity to reinvest means equal to the value of
amortization involves the necessity to eliminate the break-even of amortization from
calculation and to include the present amount of discounted tax shield in calculating the
break-even value of revenue. The formula, after proper reformulations, is as follows:

8

BEP
L
=
FC
H
%
+
_CI
RI
(1 +wACC)
n
]
wACC
1 (1 +wACC)
-n
A I
(1 I) H
%

(11)

where: RV residual value of the project

It should be emphasized that the substitution of the cost of capital (WACC) with the
target value of the internal rate of return (IRR
T
) gives the possibility of estimating the
value of revenue which allow for the achievement of IRR from the project on the
required level. An appropriate formula is shown below (formula 12):

BEP
L1
=
FC
H
%
+
_CI
RI
(1 +IRR
1
)
n
]
wACC
1 (1 +IRR
1
)
-n
A I
(1 I) H
%
(12)

where: BEP
ET
break-even value of revenue ensuring the achievement of IRR on the
required level for the project generating cash flow in a specified time horizon

In a similar way, we can arrive at a formula which allows for calculation of the value of
break-even revenue ensuring the value of NPV equalling zero, assuming that the free
cash flow grows at a constant rate. In such case, in order to calculate the value of EVA
that has to be achieved in the first period of projection, we have to use the formula for
the present value of annuity changing at the pace g. The formula is as follows:

PI = PH (1 +g) _
1
(1 +g)
n
(1 +r)
n
r g
_ (13)
where: PM the amount of the first payment of the annuity
g the rate of change in payments of subsequent elements of the annuity

In order to determine the minimum value of EVA in the first period, which changing
at the rate of g allows for the achievement of a zero NPV within the required time
horizon, it is to be assumed that:
1. PV equals the value of the capital invested in the implementation of the project
(PV = CI)
9

2. r equals the value of the weighted average cost of capital, the expected rate of
return on the investment project (r = WACC)
3. n is the number of periods of the project
4. PM equals the value of EVA achieved in the first year, which after changes at
the rate of g ensures the achievement in a specified period (n) a present value
equal to the value of capital invested in the implementation of the project (CI)
After reformulation of the formula with regard to EVA and substituting the profit (Z)
from formula 2 with it, we arrive at the following formula:

BEP
L
=
FC
H
%
+
CI
RI
(1 +wACC)
n
(1 +g) _
1
(1 +g)
n
(1 +wACC)
n
wACC g
_
A I
(1 I) H
%


(14)


5. Numerical illustration
The correctness of the presented formula can be illustrated with a simple example. Let
us assume that an investor wants to invest 12 m. zlotys in a plot and a production hall.
For running operations he also needs working capital in the amount of 0.5 m. zlotys,
which makes the capital invested (CI), necessary to implement the investment, equal at
least 12.5 m. zlotys. The capital is acquired, with the weighted average cost of capital
(WACC) at the level of 11%. Incremental fixed costs without amortization (FC) of the
project are equal 2 m. zlotys per year. The average gross margin in percents (M
%
) will
probably amount to 22%. The yearly costs of amortization are expected to be around 2.4
m. zlotys. The company pays a 19% income tax (T). According to estimations, it
appears that after the period of five years, when the investor plans to end his operations
and sell the acquired assets, the market value of the estate (after taxation) will probably
amount to around 7 m. zlotys. The investor assumes that the investment should give
back the invested capital, increased by the required rate of return within 5 years, and
that in subsequent years the replacement investments are made in the amount equal to
the costs of amortisation. Taking into account the following data, the gross receipts
ensuring the successful realization of the plans amount to 32.672 m. zlotys. The result
was arrived at by including the data into formula 10:
10


BEP
L
=
2 +2.4
u.22
+
_12.S
7
(1 +u.11)
5
]
u.11
1 (1 +u.11)
-n
(1 u.19) u.22



BEP
L
= S2.672

The result means that assuming fixed gross revenues in the amount of 32.672 m. zloty
in each of the forthcoming 5 years the project will give to the investors rate of return on
the level 11%.
Table 1 presents calculation of the value of free cash flow (according to formula 7) and
NPV of the presented project with the assumption that the value of revenues is equal to
the value of break-even revenue (formula 10).

Table 1. Calculation of NPV of the presented project with the assumption of gross
receipts on the level of break-even revenue
N 0 1 2 3 4 5
P 32.67 32.67 32.67 32.67 32.67
M% 22% 22% 22% 22% 22%
- FC 2.00 2.00 2.00 2.00 2.00
- A 2.40 2.40 2.40 2.40 2.40
= NOPAT 2.26 2.26 2.26 2.26 2.26
+ A 2.40 2.40 2.40 2.40 2.40
- WCI 0.50
- I 12.00 2.40 2.40 2.40 2.40 2.40
+ RV 7.00
= FCFF + RV -12.50 2.26 2.26 2.26 2.26 9.26

WACC 11.0%

DFCFF+DRV -12.50 2.03 1.83 1.65 1.49 5.49
Cum DFCFF -12.50 -10.47 -8.63 -6.98 -5.49 0.00
IRR 11%
NPV 0.00
Source: own work

NPI
11%
= 12.S +
2.26
(1 +u.11)
+
2.26
(1 +u.11)
2
+
2.26
(1 +u.11)
3
+
2.26
(1 +u.11)
4
+
9.26
(1 +u.11)
5

11

NPI
12%
= u

As it has already been mentioned, the application of formula 10 results in the
assumption that in each year of projection, the replacement investments are equal with
the value of amortization. However, such approach is incorrect in a situation when the
project is not characterized by the necessity for any replacement investment. In such
case, formula 12 should be used to calculate the break-even revenue:

BEP
L
=
2
u.22
+
_12.S
7
(1 +u.11)
5
]
u.11
1 (1 +u.11)
-n
2.4 u.19
(1 u.19) u.22


BEP
L
= 19.2u

Table 2. NPV calculation with the assumption of gross receipts on the level of break-
even revenue and no additional investments
n 0 1 2 3 4 5
P 19.20 19.20 19.20 19.20 19.20
M% 22% 22% 22% 22% 22%
- FC 2.00 2.00 2.00 2.00 2.00
- A 2.40 2.40 2.40 2.40 2.40
= NOPAT -0.14 -0.14 -0.14 -0.14 -0.14
+ A 2.40 2.40 2.40 2.40 2.40
- WCI 0.50
- I 12.00
+ RV 7.00
= FCFF + RV -12.50 2.26 2.26 2.26 2.26 9.26

WACC 11.0%

DFCFF+RV -12.50 2.03 1.83 1.65 1.49 5.49

Cum
DFCFF -12.50 -10.47 -8.63 -6.98 -5.49 0.00
IRR 11.0%
NPV 0.00
Source: own work

The IRR calculation presented in table 2 shows that formula 12 also allows for a correct
calculation of the value of break-even revenue ensuring the achievement of the expected
internal rate of return.
12

In addition, in order to verify the cohesion of the presented discussion, the value of
NPV has been calculated with the help of the model using EVA projection (formulas 3
and 6).

Table 3. NPV calculation with the assumption of gross receipts on the level of break-
even revenue and no additional investments
n 0 1 2 3 4 5
CIn 12.50 10.10 7.70 5.30 2.90
+ I 12.50 0.00 0.00 0.00 0.00 0.00
- A 2.40 2.40 2.40 2.40 2.40

= CIn+1 12.50 10.10 7.70 5.30 2.90 0.50
NOPAT -0.14 -0.14 -0.14 -0.14 -0.14
EVA 0.00 -1.52 -1.25 -0.99 -0.72 -0.46
RV EVA 6.50

D EVA+RV 0.00 -1.37 -1.02 -0.72 -0.48 3.58

NPV 0.00
Source: own work

NPI
11%
=
1,S2
(1 +u,11)
+
1,2S
(1 +u,11)
2
+
u,99
(1 +u,11)
3
+
u,48
(1 +u,11)
4
+
u,46 +6,S
(1 +u,11)
5

NPI
11%
= u

It is worth to notice that EVA values decrease with subsequent years of projection. It is
a consequence of devaluation of the invested capital due to the lack of replacement
investments.
The illustration of calculations made with the use of formula 14 was developed with the
assumption that free cash flow grow by 3% per year:

BEP
L
=
2
u.22
+
12.S
7
(1 +u.11)
5
(1 +u.uS) _
1
(1 +u.uS)
5
(1 +u.11)
5
u.11 u.uS
_
2.4 u.19
(1 u.19) u.22



13

Table 4. NPV calculation with the assumption of gross receipts on the level of break-
even revenue and no additional investments
N 0 1 2 3 4 5
P 18.19
M% 22%
- FC 2.00
- A 2.40
= NOPAT -0.32
+ A 2.40
- WCI 0.50
- I 12.00
+ RV 7.0
= FCFF -12.50 2.08

FCFF (1+g)^n +
RV -12.50 2.14 2.20 2.27 2.34 9.41
WACC 11.0%

DFCFF -12.50 1.93 1.79 1.66 1.54 5.58
Cum DFCFF -12.50 -10.57 -8.78 -7.12 -5.58 0.00
IRR 11.0%
NPV 0.00
Source: own work

6. Conclusion
The presented method allows for quick calculation of the scale of revenue with which a
given enterprise shall be profitable, covering not only operation costs, but also the costs
of capital. In relation to the already described methods, the solution takes into
consideration the finite time horizon of free cash flow gained thanks to investment. This
approach is not flawless, of course, and assumes a number of simplifications, e.g. the
constant level of revenue or the permanent pace of changes in the free cash flow. Still, it
makes it possible to discover if a given enterprise can be profitable in a required time
horizon quite fast. Practical application of this method in economy may also facilitate
communication between financial analysts and decision makers, since the latter of the
lack the appropriate expert knowledge in the area of methods of appraisal of investment
projects. The break-even revenue, unlike traditional NPV, is easily converted into
physical measures. At the same time, the formula enables further analyses, e.g. studying
the sensitivity to changing assumptions.

14


Literature
Bennouna K., Meredith G.G, Marchant T. (2010), Improved capital budgeting decision
making: evidence from Canada, Management Decision Vol. 48, No. 2, pp. 225 247.
Cegowski B., Mielcarz P. (2012), Wykorzystanie koncepcji obrotu granicznego w
ocenie projektw podnoszcych warto przedsibiorstwa, Przegld Organizacji, No.
2, February, pp. 27-30.
Graham J.R., Harvey C.R. (2001), The Theory and Practice of Finance: Evidence from
the Field, Journal of Financial Economics, Vol. 60, May, pp. 187243.
Jog V. M., Srivastava, A.K. (1995), Capital Budgeting Practices in Corporate Canada,
Financial Practice and Education, Vol. 5 No. 2.
Fernandez P. (2007), Valuing companies by cash flow discounting: ten methods and
nine theories, Managerial Finance, Vol. 33 No. 11. pp.853 - 876
Makowiak E. (2009), Ekonomiczna warto dodana, PWE, Warszawa.
Merchant K.A., Measuring general managers performances Market, accounting and
combination-of-measures systems, Accounting, Auditing & Accountability Journal
2006, Vol. 19 No. 6, pp.893 - 917
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Osborne M.J., A resolution to the NPVIRR debate?, The Quarterly Review of
Economics and Finance 2010, Vol. 50
Ostaszewski J., Cicirko T., Kreczmaska-Gigol K., Russel P., Finanse spki akcyjnej,
Difin, Warsaw 2009
Ryan P.A., Ryan G.P., Capital Budgeting Tools of the Fortune 1000, Journal of
Business and Management 2002, Vol. 8 No. 4


15

Application of break-even revenue concept in assessment of investments
generating time-limited free cash flows

Summary
In spite of the fact that capital budgeting methods are widely discussed in financial
literature, there are still difficulties with the theory implementation in practice. The
reasons for this situation are easy to identify. In case of the methods of preliminary
analysis (eg. payback period, break-even point) the very far-reaching simplification are
indicated. On the other hand the use of more advanced methods (e.g., NPV, EVA)
requires expertise in free cash flows and discount rates forecasting, the skills which are
not very common among managers responsible for investment decisions. The article
presents a method developed by the authors which combines different tools. The created
method gives an easy to interpret information about value of sales which guarantees
NPV equals 0 in a given period of analysis.


Keywords: break-even, payback period, NPV, EVA, WACC


Zastosowanie koncepcji progu rentownoci w ocenie inwestycji generujcych
ograniczone czasem wolne przepywy pienine

Streszczenie
Temat analizowania opacalnoci inwestycji zosta szczegowo opisany w literaturze
przedmiotu, wci wystpuj jednak problemy z prawidow implementacj teorii w
praktyce. Powody takiej sytuacji mona stosunkowo atwo zidentyfikowa. W
przypadku metod zaliczanych do analizy wstpnej (np. okres zwrotu, prg rentownoci)
zwraca si uwag na zbyt daleko idce uproszczenia. Zastosowanie metod bardziej
zaawansowanych (np. NPV, EVA) wymaga z kolei specjalistycznej wiedzy z zakresu
prognozowania przepyww pieninych i stopy dyskontowej, ktrej czsto nie
posiadaj osoby ostatecznie podejmujce decyzje o realizacji bd odrzuceniu
projektw inwestycyjnych. W artykule zaprezentowana zostaa opracowana przez
autorw metoda, ktra pozwala wykorzysta zalety wymienionych narzdzi i przy
pomocy jednego wzoru wyznaczy atw do interpretacji warto przychodw, przy
16

ktrych NPV w przyjtym do analiz okresie wyniesie 0, a wic finansujcy otrzymaj
zwrot z inwestycji na wymaganym poziomie.

Sowa kluczowe: prg rentownoci, okres zwrotu, NPV, EVA, WACC