Economic Analysis Concepts

8/4/2019 Economic Analysis Concepts

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All project economic analysis should be performed based on the followingconcepts:

Net cash flow to energy inc.The cash flow from investment proposals must be analyzed on a comparablebasis in order to determine which proposals have the greatest economic valueto Energy Inc. Therefore all investments should be evaluated on the basis of

after-tax U.S. Dollar cash flow to Energy Inc. A project's cash flow shouldinclude all foreign tax effects, such as income and remittance taxes, and anyU.S. Income tax effects.

Weighted average cost of capital (WACC)This is the rate used to discount future project net cash flow. The cost of

capital is the weighted average after-tax cost of debt, preferred and commonstock in Energy Inc.s capital structure. The WACC is calculated by the financedepartment and issued by the comptroller.

ECONOMIC ANALYSIS CONCEPTS


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Current dollar basis.

All cash flow should be stated in current (nominal) dollars (i.e. actualamounts which are expected to be expended or received each year). Current

dollar forecasts represent changes due to inflation and any real price change

above or below inflation. The rates used should be consistent with the most

recent forecast provided by corporate.

Foreign currency exchange rates.

Forecasted cash flows based on local currencies should be converted into U.S.

Dollars using current currency exchange rates.



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Full cycle or full life economics.

Economic value of an asset that was acquired in the past andhad its value enhanced through additional investments.

Results do not represent the current economic value to thefirm since the analysis includes prior investment, revenueand expenses.

Results include the benefit of hindsight and are useful toimprove decisions made in the future.



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The following four measures are commonly used inproject analysis. Each one provides importantinformation on the attractiveness of a project.

Net Present Value (NPV) Present Worth Payout (PWP)

Discounted Cash Flow Return on Investment (DCFROIor IRR)

Present Worth Index (PWI)

ECONOMIC MEASURES


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Net Present Value (NPV)

The net present value is the economic value expected to be generatedby the project at the time of measurement. It represents the value

being added to the Company by making the investment.

Decision Rule NPV>0

Limitations A larger investment will normally have a larger present value. A ranking based

simply on net present value would therefore tend to favor large investments

over small investments.

Does not consider length of time to achieve that value.

ECONOMIC MEASURES


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Present worth index (PWI)PWI measures the relative attractiveness of projects per dollarof investment. The ratio of the present value of cash inflows tothe present value of the cash outflows. Designed to address thelimitation of NPV cited above .

Limitations. It is not a good indicator of the significance of a project.

Is dependent on cost of capital used. If cost of capital is over or

underestimated could result in selection of wrong project.

ECONOMIC MEASURES


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Present worth payout (PWP)payout measures the time that the net investment willbe at risk. The longer the payout period, the morechance for some unfavorable circumstance to occur.

Limitation: Disregards cash flows received after the payout period. It

does not directly measure the value created by the project.

Is dependent on cost of capital used.

ECONOMIC MEASURES


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Discounted cash flow return on investment(DCFROI/IRR).Measures the efficiency of the project in producing valuewithout reference to any predetermined cost of capital.The discount rate which equates the project's discounted

net cash inflows with its discounted net cash outflows.

Decision rule IRR>Cost of capital.

Limitation:

Favors projects with a quick payout or short-term in nature.

ECONOMIC MEASURES


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FUNDAMENTAL ANALYSIS


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Fundamental Analysis

Approach to Fundamental Analysis

Domestic and global economic analysis

Industry analysis

Company analysis

Why use the top-down approach

FRAMEWORK OF ANALYSIS


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SHOCKS TO FINANCE AND GROWTH

Shock to bothstock market andmacroeconomy

Shock tomacroeconomy

Shock tostock market

Stock Market Macroeconomy


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Performance in countries and regions is

highly variable

Political risk

Exchange rate risk Sales

Profits

Stock returns

GLOBAL ECONOMIC CONSIDERATIONS


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Gross domestic product

Unemployment rates

Interest rates & inflation

Budget Deficits

Consumer sentiment

KEY ECONOMIC VARIABLES


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DETERMINATION OF THE EQUILIBRIUM REAL

RATE OF INTEREST


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Fiscal Policy - government spending and taxing

actions

Direct policy

Slowly implemented

FEDERAL GOVERNMENT POLICY


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Monetary Policy - manipulation of the money supply

to influence economic activity

Initial & feedback effects

Tools of monetary policy

Open market operations( federal funds rate)

Discount rate

Reserve requirements

FEDERAL GOVERNMENT POLICY (CONT.)


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Demand shock - an event that affects demand forgoods and services in the economy

Tax rate cut

Increases in government spending

DEMAND SHOCKS


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Supply shock - an event that influences productioncapacity or production costs

Commodity price changes

Educational level of economic participants

SUPPLY SHOCKS


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Business Cycle Peak

Trough

Industry relationship to business cycles

Cyclical

Defensive

BUSINESS CYCLES


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Leading Indicators - tend to rise and fall in

advance of the economy

Examples

Avg. weekly hours of production workers

Stock Prices

Initial claims for unemployment

Manufacturers new orders

NBER CYCLICAL INDICATORS: LEADING


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Coincident Indicators - indicators that tend to

change directly with the economy

Examples

Industrial production Manufacturing and trade sales

NBER CYCLICAL INDICATORS:

COINCIDENT


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Lagging Indicators - indicators that tend to follow

the lag economic performance

Examples

Ratio of trade inventories to sales

Ratio of consumer installment credit outstanding to

personal income

NBER CYCLICAL INDICATORS: LAGGING


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Sensitivity to business cycles

Sector Rotation

Industry life cycles

INDUSTRY ANALYSIS


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ESTIMATES OF EARNINGS GROWTH RATES IN

SEVERAL INDUSTRIES, 2004


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Factors affecting sensitivity of earnings to businesscycles Sensitivity of sales of the firms product to the business

cycles Operating leverage

Financial leverage

SENSITIVITY TO BUSINESS CYCLE


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A STYLIZED DEPICTION OF THE

BUSINESS CYCLE


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FIGURE 17.6 RETURNS ON EQUITY, 2005


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FIGURE 17.7 RATE OF RETURN, 2005


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Selecting Industries in line with the stage of thebusiness cycle

Peaknatural resource firms

Contractiondefensive firms

Troughequipment, transportation and

construction firms

Expandingcyclical industries

SECTOR ROTATION


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SECTOR ROTATION GAINS


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Total returns on a representative group ofFidelity Select funds from 1999 to 2003 (fund

with highest return for the year in blue).

Yr Biotech Finance Const. Media Gas Tech Wilshire

1999 77.8% 30.6% 12.5% 44.1% 26.2% 132.4% 23.6%

2000 32.8% 28.3% 8.8% -23.1% 71.0% -31.8% -10.9%

2001 -25.0% -9.2% 20.0% -1.0% -22.9% -31.7% -11.0%

2002 -40.5% -17.2% -8.5% -12.8% -9.6% -37.8% -20.9%

2003 32.9% 36.5% 44.1% 43.9% 28.7% 59.4% 31.6%

HISTORICAL SECTOR PERFORMANCE
http://www.alphaprofit.com/fidelity-select-fund-list.htmlhttp://www.alphaprofit.com/fidelity-select-fund-list.html


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Stage Sales Growth

Start-up Rapid & Increasing

Consolidation Stable

Maturity Slowing

Relative Decline Minimal or Negative

INDUSTRY LIFE CYCLES


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THE INDUSTRY LIFE CYCLE


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Economic Analysis Concepts