Basic Finance: Valuation Chapter VI, Evaluation of investment projects

Evaluation of investment
projects

Basic Finance: Valuation Chapter VI, Evaluation of investment projects

Starting point: Price, Value and Valuation (Chapter 1 Basic Concept )

Theories of value; Time value of money

Formula: Evaluation is the process of value quantification

Content:

Types of cash flows

1. Net present value (NPV)
Net Cash Flows
Present value
Discount rate
2. Internal rate of return (IRR)
IRR evaluation criterion
The case of mutual exclusive investment projects with divergent NPV and IRR

criteria
3. Payback period (PP)

Basic Finance: Valuation Chapter VI, Evaluation of investment projects

Three types of cash flows and captions (at the level of companys projected cash flow statement):
A. Cash flow from operating activities
Direct Method

Indirect Method

+ Cash collections from operation

+ Net profit before taxation and interest

- Cash payments for operation (interest included )

+ Adjustment for calculated expenses

- Adjustment for calculated revenues
- Increase / + Decrease of working capital
- Interest paid
- Income tax paid

B. Cash flow from investing activities

- Purchase of property, plant and equipment (Investment Cost)
+ Proceeds from sale of equipment (Residual Value)

C. Cash flow from financing activities

- Reimbursement of / Proceeds from long-term borrowings
- Payments of / + Proceeds from finance lease liabilities
- Dividends paid

Basic Finance: Valuation Chapter VI, Evaluation of investment projects

Companys cash flow items and their relevance for evaluation of investment projects

Direct Method

Indirect Method

Relevant / Irrelevant for

evaluation of investment
projects

+ Cash collections from operation (Relevant)

+ Net profit before taxation and interest

- Relevant

- Cash payments for operation (interest included )

+ Adjustment for calculated expenses

- Relevant

- Adjustment for calculated revenues

- Relevant

- Increase / + Decrease of working capital

- Relevant

- Interest paid

- Irrelevant

- Income tax paid

- Relevant

A. Cash flow from operating activities

(Relevant, except for interest paid)

B. Cash flow from investing activities

- Purchase of property, plant and equipment (Investment Cost)
+ Proceeds from sale of equipment (Residual Value)

- Relevant
- Relevant

C. Cash flow from financing activities

- Reimbursement of / Proceeds from long-term borrowings
- Payments of / + Proceeds from finance lease liabilities
- Dividends paid

- Irrelevant
- Irrelevant
- Irrelevant

Basic Finance: Valuation Chapter VI, Evaluation of investment projects

Three key measures for evaluation of

investment projects:
1. Net present value (NPV)
2. Internal rate of return (IRR)
3. Payback period (PP)
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Basic Finance: Valuation Chapter VI, Evaluation of investment projects

NPV
Net Cash Flows (Cash Inflows Cash Outflows)

NCFt = RCt CPt, with t = 0..n;

where:
RC = revenues collected (cash inflows), including both operating revenues and revenues from fixed assets
sold (residual value);
CP = costs and expenses paid (cash outflows), including both investment cost and operating expenses paid;
t = the period (year) of cash flow;
n = investments estimated life period.

Basic Finance: Valuation Chapter VI, Evaluation of investment projects

NPV
Present Value

- Time value of money (already presented in the 1st Chapter)

- Money amounts with different time values are made comparable by

discounting and taking their present values

Basic Finance: Valuation Chapter VI, Evaluation of investment projects

NPV
Present Value

- Discounting of cash flows:

NCF0 NCF1 NCF2

NCF1
(1 k )1

NCF2
(1 k ) 2

NCFn
(1 k ) n

N
C
F
0

N
C
F
1

N
C
F
1

NCFn

N
C
F
2

N
C
F
n
1

N
C
F

Timen

N
C
F
0

Basic Finance: Valuation Chapter VI, Evaluation of investment projects

NPV
Present Value

- By discounting, even if the net cash flows have different time values,
they can be cumulated and their sum provides a proper efficiency
measure NPV (general formula):
NCFi
NPV =
i
i 0 (1 k )
n

Where: k = the discount rate

A simplified approach:
n

NPV =

I
i 1

NCFOi
RV

(1 k ) i (1 k ) n

Where: I = cost of investment, expected to occur over a single year (year 0)

RV = residual value, collected in the end of projects life (year n)
NCFO = operating net cash flow, for the rest of the projects years (1..n)
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Basic Finance: Valuation Chapter VI, Evaluation of investment projects

NPV
Discount rate
Double role of this rate in the discounting of cash flows:
1. Allows to compare net cash flows with different time value

2. Provides a key benchmark for the analysis (it works as a test used for rejection or acceptance of
the investment project)
- NPV > 0 : return provided by the investment project is higher than the discount rate
- NPV = 0 : return provided by the investment project is at the same level with the discount rate
- NPV < 0 : return provided by the investment project is less than the discount rate

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Basic Finance: Valuation Chapter VI, Evaluation of investment projects

NPV
Discount rate
Cost of Capital
Main capital source

Specific finance sources

Costs of capital

Common shares

Expected rate of return

Preferred shares

Fixed rate of return

Bond Debts

Coupon rate

Long Term Banking Debts

Long term banking interest rate,

specific to the projects risk

Leasing Debts

Leasing interest rate

Short Term Banking Debts

Short term banking interest rate,

specific to the projects risk

Suppliers Debts

Only possible opportunity costs

Risk

Return

High

High

Equity

Debts

Low

Low

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Basic Finance: Valuation Chapter VI, Evaluation of investment projects

NPV
Discount rate
Weighted Average Cost of Capital (w.a.c.c.)
n

w.a.c.c. =

pc
i 1

i i

Where: pi = weight of the capital sources, i = 1..n

n = total number of capital sources
ci = specific costs of different capital sources, for debts ci is multiplied by (1-t) fiscal shield of debts

Weighted Average Cost of Capital (w.a.c.c.) = the most suitable benchmark for discounting
- NPV > 0 : project provides a return over its cost (acceptance)
- NPV = 0 : project provides a return at the level of its costs (acceptance depending on project risks
and equity providers flexibility related to the expected return)
- NPV < 0 : project provides a return less than its cost (rejection*)
* Except for the public investment projects with public benefits

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Basic Finance: Valuation Chapter VI, Evaluation of investment projects

NPV
Discount rate
Weighted Average Cost of Capital (w.a.c.c.) simplified financial structure

Example:

Financial structure

pi

ci

Equity

25%

20%

Debts

75%

13%

w.a.c.c. = 25% 20% + 75% 13% = 14.75%

if income tax is 0% (off shore investment)
If 16% income tax is considered:
w.a.c.c. = 25% 20% + 75% 13% (1-16%) =
= 13.19%
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Basic Finance: Valuation Chapter VI, Evaluation of investment projects

IRR
IRR evaluation criterion
IRR: discount rate which provides null NPV
(using internal return as benchmark is like looking in a mirror)

NCFi
NPV(IRR) =

i
(
1

IRR
)
i 0
n

=0

NPV(k) monotony decreasing:

NCFi
NPV(k) = i
i 1 < 0 => NPV(k) <=> k1 > k2 => NPV(k1) < NPV(k2)
(
1

k
)
i 1
n

14

Basic Finance: Valuation Chapter VI, Evaluation of investment projects

IRR
IRR evaluation criterion
NPV (k)

N
P
V
(
k
)

IRR

NPV (k1)

N
P
V
(
k
1

NPV (k2)

E(IRR)

)
N
P
V

k1

I
R
R

E
(
I
R
R
)

k2
k
1

k
2

k
a

(
k

Estimation of the IRR based

on linear interpolation procedure E(IRR)
)
2

NPV (k1 )
E(IRR) = k1 + (k2 - k1) NPV ( k ) NPV ( k )
1
2
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Basic Finance: Valuation Chapter VI, Evaluation of investment projects

IRR
The case of mutually exclusive investment projects with divergent NPV and IRR
criteria
N
P
V
(
k
)

NPV (k)
N
P
V

NPV1

NPV2

N
P
V
2

k1

I
R
R

IRR2

k2

IRR1

I
R
R

Fig. 6.3. The case of mutual exclusive investment peojects with divergeant NPV and
IRR criteria

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Basic Finance: Valuation Chapter VI, Evaluation of investment projects

PP
Three forms:
pp

1.

NCF
i 0

=0

pp

NCFi
2.
i
i 0 (1 k )
3. PP =

=0

I
YCFO

where:
YCFO = estimated yearly average discounted net cash flow from operation and
investment
I = investment cost
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