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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.
ECONOMIC ANALYSIS CONCEPTS
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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.
ECONOMIC ANALYSIS CONCEPTS
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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
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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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