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Financial Concepts PDF
Financial Concepts PDF
Financial Concepts PDF
0 08/2006
Introduction
All capital investment decisions involve the concept of
investing funds at the present time with the
expectation of receiving a return at some future date.
Need to be examined estimated future streams of
income in an attempt to determine value.
Need to be fully understood the role of the time value
of money as this forms the basis for any financial
analysis or valuation.
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EVALUATION GUIDELINES
Made at a point in time
Sunk costs
Constant $ or current $
For comparing alternatives, make sure techniques
used permit fair comparisons
Manual evaluations
Computer financial models
Investment decision versus sale/purchase
evaluation
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CASH
Cash is the lifeblood of the enterprise
Cash flows are actual $ spent or received
Non-cash items (e.g. depreciation) are
important as far as they affect cash flows
Project cash flows for a period are inflows
minus outflows - may be +ve or -ve
Periods are usually years; may be quarters or
months, depending on the size of the project
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WORKING CAPITAL
Component of intial cap. ex. - to fund op. costs
until sales revenues arrive - in theory recovered
at end of mine life
Required throughout project life but generally
supplied by sales revenues
Itemised on a period by period basis in detailed
financial models
Avoid double counting in financial model but
must be counted in initial funding requirement
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CURRENCY
Local currency
Because costs in local currency
Convert revenues to local currency
Forecast exchange rates can dominate the
evaluation
Foreign projects in host country currency
In cases of foreign country hyperinflation, use a
stable currency, e.g. US$, if sales revenues in
US$
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CONSTANT VS CURRENT $
$ change in value over time
Constant $ - generally average value of $ of the day at
time of evaluation, preserved throughout project life.
Current $ - $ of the day for each period in the future requires calculation of the change in value from period
to period, i.e. usually inflation rates
Costs affected by local inflation, revenues by world
inflation, up to a point. Mineral commodity revenues
controlled by supply and demand most of the time.
INTEREST RATES
A function of the time value of money
On debt, represent low risk return
Therefore, risky investments offer higher
return
Diversified equity investments offer about
6% above the risk free rate
Government bonds represent risk free rate
Interest rates and discount rates closely
linked
Discounting Techniques
Simple interest
Simple interest is calculated by application of the rate to the initial
investment principal each interest compounding period. Total interest paid
over the repayment is proportional to the length of the loan schedule.
Cumulative payment (simple interest) = P i n
Example
$1,000 principal at simple interest of 6% per annum for 120 days gives
Solution
Simple interest = $1,000 0.06 (120/365) = $19.73
Discounting Techniques
Compound interest (period, nominal, effective and
continuous)
Compound interest is calculated separately for each period
within the repayment schedule.
Interest paid in a period is the rate multiplied by the
outstanding principal for that period.
Rate = x per cent per TIME FRAME compounded each
PERIOD LENGTH
Normally, compound interest rates are expressed using a
TIME FRAME of a year. However, the PERIOD LENGTH for
compounding is very often a much shorter time such as a day
or a month.
P(1+i)n = F
More Examples
Calculate the future worth that $2,000 today will have 4 yrs
from now if interest is 5% per yr compounded annually.
P(1+i)n = F
The F/Pi,n factor can be found from interest tables or it can
be calculated mathematically to be (1 + 0,05)4=1.216
F = P(1+i)n
F = 100(1+0.10/2)2*3 = 100(1+0.05)6
1 + 1
m
0 .1
= 1 +
1 = 10 .3%
2
o HINT:
1 + 1
m
INTEREST FORMULAS
o Future Value F of a present amount P:
F = P (1+i)n
o Ex.: You deposit $5000 today @10% interest for five years.
How much will accumulate of we compound annually?
Answer: $8,052.50
o What if we compound semiannually?
Answer: $8,144.50
o Find P of $5000 received at the end of 5 years.
Answer: $3,104.50
ANNUITY
Set of money payments made periodically under certain stated
conditions.
o Annuity certain = fixed number of payments
o Contingent annuity = number of payments conditional
o Life annuity = made during the life of a person
o F = sum at the end of n periods; P = Present value
(1 + i )n 1
F = A
ANNUITY
How much will accumulate in a fund if $2,500 is invested each
year for 5 years at 10%?
Answer: $15,262.5
o HINT:
(1 + i )n 1
F = A
SINKING FUND
Equal payments which will amount to some Future Value at the
end of n years @ i% interest.
o Transpose the equation for Annuity!
i
A = F
n
(1 + i ) 1
o (A/F, i, n) => sinking fund factor:
Find A given F
UNIFORM SERIES
Present value of an Annuity
o Formula:
(1 + i ) n 1
P = A
n
i (1 + i )
o (P/A, i, n) => sinking fund factor: Find P given A
CAPITAL RECOVERY
Used in typical car and home loan..
o Formula:
i (1 + i )
A = P
n
(1 + i ) 1
n
PROJECT PERIODS
Equal length periods cover entire life of project
Permits use of standard compound interest
relationships and rules
Periods = years, generally
May be quarters or months for small projects
Project commences with the first period of
investment
Evaluation relates to beginning of first period
DEPRECIATION
Depreciation is the means of recovering capital
expenditure
Deducted from taxable income because it is recovered
capital, not income
But, since dividends cannot be paid out of capital,
accountants concentrate on the after tax profit without
adding back depreciation
Discounted cash flow evaluations add back depreciation
to evaluate total cash flows of the project.
Dividend payments are not part of the project evaluation.
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more NPV
A project achieves economic acceptability when the
sum of discounted receipts exceeds the sum of
discounted expenditures.
Discount Rate
Theoretically, if the project investment is considered to be riskless, the
discount rate should be the highest risk free rate available to the investor.
No mining investment is risk free.
Many companies tend to use their long run weighted average cost of funds
as the discount rate, as that reflects a market perception of the required
rate of return from such a company.
Some companies increase the discount rate above their cost of capital to
take account of the perceived riskiness of a specific project or in the hope
of identifying potentially higher earning projects.
In that case, the discount rate is called the hurdle rate.
IRR
For the most common investment projects, which
involve mainly negative cash flows in the early
years and predominantly positive cash flow in
later years, the NPV is an inverse function of the
discount rate and a zero NPV is generated by a
unique discount rate, called the Internal Rate of
Return (IRR).
In those cases, the NPV goes down as the
discount rate goes up
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There can be no unique NPV for any project.
For the most common investment projects, which involve
mainly negative cash flows in the early years and
predominantly positive cash flow in later years.
- If NPV > 0, the project obtains income which is more than
anticipated interest rate
- If NPV = 0, the project obtains income just for anticipated
interest rate
- If NPV < 0, the project obtains income which is less than
anticipated interest rate
NPV vs DCF
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more PVR
The alternative method of calculating the PVR is to divide the present
value of all project cash flows excluding capex by the present value of
all capital expenditures, both streams being discounted at the same
rate.
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Example 1
A company must decide whether to introduce a
new product line. The new product will have
startup costs, operational costs, and incoming
cash flows over six years.
This project will have an immediate (t=0) cash
outflow of $100,000 (which might include
machinery, and employee training costs).
Other cash outflows for years 1-6 are expected
to be $5,000 per year. Cash inflows are
expected to be $30,000 per year for years 1-6.
All cash flows are after-tax, and there are no
cash flows expected after year 6.
The discount rate is 10%. Calculate the PV for
each year??
$8,881.52
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Example 1
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Example 2
A five year project requires investments of $120,000 at time zero and
$70,000 at the end of year 1 to generate revenues of $100,000 at the end of
each of years 2 through 5. The minimum rate of return is 15%. Calculate the
project NPV and ROR to determine if the project is economically acceptable.
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Example 2
Rate of Return (ROR)
@30% =-7,212
@25%=12,928 == by iterating i = 25%+5%(12,928/20,140)=28.2%
>15% economically satisfactory
Trial and error basis
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NPV Example
Economic Evaluation
You cannot manage what you cannot measure
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NPV Analysis
Simple to calculate
Take into account risk
Allows comparison of project with different profiles
Independent of inflation
But;
Does not take into account a project managers
ability to adapt to future changes as they occur.
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Corporate Objectives
Lowest quartile of the cost curve
Develop world class deposits
Hedge to protect investors of price market
fluctuations
Not hedge to expose investors to the market
Increase value through expansion in reserves
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NPV Curve
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Design Criteria
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NPV ($ million)
20
15
10
5
0
0
100
200
300
400
500
600
700
800
-5
-10
-15
NPV $14/g
NPV $18/g
900
1000
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