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8/9/2019 Investment annalysis
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Investment Analysis
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Financial Costs and Benefits
Based on Time Value of Money
BenefitCost Ratio
Net Present Worth or Net Present Value (NPV)
Internal Rate of Return (IRR)
Risk Analysis
Debt coverage Service Ratio (DCSR)
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Cost-Benefit Analysis
3
Scientific criteria to evaluate projects
Determines the scale of the project on the basis of maximation of thedifferences between benefit and cost
Cost-benefit analysis (CBA), or benefitcost analysis (BCA), is used toassess benefits and costs of a project
Purpose of CBA is;
Determine if it is a sound investment/decision
Basis to compare projects. Compares the total expected cost of each optionagainst the total
expected benefits, to see whether the benefits outweigh the costs,and by how much.
CBA focuses on economic efficiency
Calculates net benefits for each project
to describe and quantify the social advantages and disadvantages of the policy
in terms of a common monetary unit
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Criteria for CBA There are 4 CBA; - B-C, B-C/1, B/C & B/C B/C is ratio method used to evaluate the project
If B/C=1; the project is marginal.(i.e. just covering the costs) If B/C>1; (Accepted)widely used in markets to reap maximum benefits If B/C
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Need of CBA
5
Recent government decisions give renewed focus to CBA
Agencies need to build their capacity to use CBA to improve the
quality of regulatory and financial analysis
Greater use of CBA expected by government for regulatory
proposals
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Why is CBA useful?
6
Takes a community-wide perspective
Allows the consideration of a range of policy options
Determines which proposal maximises net benefits to the
community
Allows benefits and costs to be compared over time
Represents the costs and benefits accruing to different groups
within the community
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Financial Costs and Benefits
In B/C Ratio, we try to assess how much of our
present costs and benefits are worth at a future
point of time.
The costs and benefits are discounted and
assessed for the present.
Rs.1000 today is not the same as it would be
five years from now.
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Financial Costs and Benefits
Rs.1000 today would have to be something
more than Rs.1000 next year.
How much it should be depend upon the
premium we place on that Rs.1000.
In other words, how much we want to use it
for the present (present consumption) and
how much we want to use it in future?
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You have a proposal to build a 3 power generating station of10 MW each costing 3 million. The expected life of the projectis 10 years, during which, there is adequate demand Site
available is perfectly suited 3 Power PlantsExpected life of project 10 Years
Each 10 Mega Watt Plant costs 3 million
Accessories and Other costs 1 million
Initial Investment ( 3 power stations * each 10 MW cost +accessories cost) 10 million
Over next 10 yrs expected revenue 35 million
Each year expected revenue 3.5 million/annum
Incurring costs for 10 years 15 million
Incurring cost per year (O&M costs) 1.5 million/annum
Total Cost (for DBFO) of the plant (Costs) (3*3+1+15) 25 million
Benefits for 10 years 35 millionBenefits> Costs
Option 1
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You have a proposal to build a 1 power generating station of 60MW. The expected life of the project is 10 years, during which,there is adequate demand Site available is perfectly suited 1 Power Plants
Expected life period 10 years
Each 60 Mega WattPlant costs 13 million
Accessories and Other O&M costs 2 million
Initial investment (1 * each 60 megawatt cost +accessories cost) 15 millionOver next 10 yrs expected revenue 48 million
each year expected revenue 4.8 million/annum
Incurring costs for 10 years 20 million
Incurring cost per year 2 million/annum
Total Cost for DBFO of the plant (Costs) - (1*13+2+20) 35 millionBenefits for 10 years 48 million
Option 2
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Costs and Benefits
Year 1 Total Costs
Total
benefits
Discounting
@10% NPW Costs
NPW
Benefits
1 50 0 0.91 45.45 0.00
2 50 0 0.83 41.32 0.00
3 0 40 0.75 0.00 30.05
4 0 60 0.68 0.00 40.98
5 0 75 0.62 0.00 46.57
100 175 86.78 117.60
Benefits - Costs ratio 1.36 (i.e. PV of B / PV of C)
The total cost of the project is 100 invested in first two years. i.e.50, 50
The total benefits of the project is 175 in which payments are received
for the next three years i.e. 40, 60, 75 respectively. Life period of theproject is 5 years. Calculate CBR taking 10% as an DF and convey
whether Project is accepted or rejected.
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The total cost of the project is 300 invested in first
two years i.e. 175,125. The total benefits of the
project is 600 in which payments are received for
the next three years i.e. 150, 200, 250 respectively.Life period of the project is 5 years. Calculate CBR
taking 10% as an DF and convey whether Project is
accepted or rejected.
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Present value
13
The current worth of a future sum of money or
stream of cash flows given a specified rate of return
Future cash flows are discounted at the discount
rate, and the higher the discount rate, the lower the
present value of the future cash flows Present value, also known as present discounted
value
Used to make comparisons between cash flows
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Present Value
14
To calculate the present value of any futureamounts Single amount
Varying amounts
Annuities
Present value formula for a single amount is:
1) PV = FV (1 + i)-n (or)
2) PV = FV x [ 1 (1 + i)
n
]PV = Present valueFV = Future Valuei= rate of interest
n= number of years
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Single Amount - Calculation 1
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1) Calculate the present value (the value at time period) of receiving a single amount of1,000 in 20 years. The interest rate for discounting the future amount is estimated at
10% per year compounded annually.PV=?? FV=1,000
.....
1 year 1 year 1 year 1 year
0 1 2 3 19 20
n = 20 years; i = 10% per year
The answer tells us that receiving 1,000 in 20
years is the equivalent of receiving 148.64
today, if the time value of money is 10% per
year compounded annually.
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Method 1:
PV = FV (1 + i)-n
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Calculation 2
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Calculate the present value of a single amount
of 1,00 at the end of 2 years assuming the
interest rate of 8% per year compounded
annually.
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Calculation 3
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What is the present value of receiving a single amount of 5,000
at the end of three years, if the time value of money is 8% per
year, compounded quarterlyPV=?? FV=5,000
.....
3 months 3 months 3 months 3 months
0 1 2 3 11 12
n = 12 quarters (3 years X 4 quarters each year); i = 2% per quarter
PV= 3,942.45
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Future Value
19
Value of an asset or cash at a specified date in thefuture that is equivalent in value to a specifiedsum today
Two ways of calculating future value:
Simple interest For an asset with simple annual interest = Original
Investment x (1+(interest rate*number of years))
Compound interest For an asset with interest compounded annually=
Original Investment x ((1+interest rate)^number ofyears)
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Calculation -1 (using Simple Interest)
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FV= PV*(1+rt)PV=Present value
R= rate of interest
T= time period
1000 invested for 5 years with simple annual
interest of 10% what will be the future value?
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21
1000 invested for 5 years with compoundedannual interest of 10% what will be the futurevalue?
FV= PV*(1+i)t
PV=Present value
i= rate of interest
t= time period
= 1000*(1+0.10)5
= 1000*(1.10)5
= 1000*(1.610)
=1610.51
Calculation -1 (using Compound
Interest)
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Annuities
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Annuities - series of fixed payments required fromyou or paid to you at a specified frequency over
time period.
Payment frequencies - Yearly, Semi-annually (twicea year), Quarterly and Monthly.
There are two basic types of annuities:
Ordinary annuities : Payments are required at the end of each period. Future Value
Present Value
Annuities due: Payments are required at the beginning of each period.
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Present Value (PV)Ordinary annuities
23
To determine today's value of a future payment Calculates the PV of the payments that you will receive in the
future.
Investing 1000 per year for the next 5 years, and investing that at
the 5%
Present value of an ordinary annuity returned a value of 4,329.48.
The present value of an ordinary annuity is less than that of anannuity due because the further back we discount a future
payment, the lower its present value
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Net Present Value
Net Present Value (NPV):The sum of the present valuesof all cash inflows minus the sum of the present values of
all cash outflows.
Appreciates time value of money
Only cash profits are important
Additive method
Provides a direct link between management decision and
shareholder value
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Calculation 1:The total cost of the project is 100 RS invested in
first two years. The total benefits of the project is 175 in which
payments are received for the next three years i.e. 40, 60, 75
respectively. Life period of the project is 5 years.
Year 1
Total
Costs
Total
benefits
Discounting
@10%
Net
benefits
Discounting
NB @10%
1 50 0 0.91 -50 -45.45
2 50 0 0.83 -50 -41.32
3 0 40 0.75 40 30.05
4 0 60 0.68 60 40.98
5 0 75 0.62 75 46.57
100 175 75 117.60
NPV = 30.83???
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Internal Rate of Return (IRR)
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The internal rate of return (IRR): The rate atwhich the sum of discounted cash inflow equalsthe sum of discounted cash out flow.
In other words, it is the rate which discounts thecash flow to zero.
The internal rate of return measures theinvestment yield.
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NPV v/s IRR
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The acceptance and rejection is done base onthe IRR rate
NPV IRR
It takes interest as a known factor It takes interest as a unknown factorIt calculates the exact amount ofinvestment (represents in currency)
It calculates the maximum rate ofinterest (represents in percentage terms
Generates different results wherediscount rates are applicable It gives predictions
NPV is preferred as it is widely used IRR vastly used at corporate level
If NPV>0, then project is accepted innature
IRR is a parameter that can be used torank several projects. The higher the IRRthe most desirable is the project.
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How to Assess
the Internal Rate of Return ?
At what rate the project is profitable?
For this we use the Internal Rate of Return
It is that rate which makes the NPV=0 and the
B/C Ratio =1
IRR represents the average earning power ofmoney used in the project over the project
life.
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Year Costs Benefits
Net
Benefits
DF
@10%
NPV
@10%
DF
@25%
NPV
@25%
DF @
19.00%
NPV
@19%
1 150 0 -150 0.91 -136.36 0.80 -120.00 0.84 -126.05
2 5 25 20 0.83 16.53 0.64 12.80 0.71 14.12
3 5 50 45 0.75 33.81 0.51 23.04 0.59 26.70
4 5 75 70 0.68 47.81 0.41 28.67 0.50 34.90
5 5 125 120 0.62 74.51 0.33 39.32 0.42 50.28
170 275 105 172.66 103.83 126.02
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IRR = {(Lower Discount Rate) + (Difference between
Higher and lower discount rate)} * [NPV at lower
Discount rate/Absolute difference between NPV
At two discount Rates that is total NPVs
IRR = (10) + (15) * [36.2 / (36.2+16.2)]= (10) + 15 * ( 0.69) = 10+10.35
= 20.35%
Formula for IRR
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Once we arrived at the IRR , in this case 20.35%,
we compare that with that of the market rate of
interest.
If the market rate of interest is above this, the
project is rejected.
If it is below this , the project is selected.
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Risks and uncertainties
UncertaintiesDifficult to incorporate in to
project design just because it is uncertain.
RisksWe can take measures to minimise
this.
Risk measurements are very well developed
now.
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Risk Analysis
Here we concentrate only on three issues:
Variations in BenefitsHow much can we
tolerate without dropping a project?
Variations in Costs - How much can we
tolerate without dropping a project?
How much delay the project can afford?
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Risk Analysis
Present value of benefitsPV of Costs
Variations in Benefits = ------------------------------------------------------Present Value of Benefits
Present value of benefitsPV of Costs
Variations in Costs = ------------------------------------------------------Present Value of Costs
Present value of Costs
Variations in time = ------------------------------------------------------
Present Value of Benefits
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94004206
Variations in Benefits = ------------------------- = 55%9400
9400 - 4206
Variations in Costs = -------------------- = 123%4206
4206
Variations in time = ----------------- = 0.45
9400
Using a 10% discount factor, this 0.45 is equivalent to 8 years.
Risk Analysis
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