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