TÍTULO

INTRODUCTION TO FINANCE
V –PROJECT EVALUATION 1
 PROJECTS

 Definition:
 Use of resources in order to recover them later with a financial surplus

 Types of Projects
 Investment
 Financing
 TYPES OF PROJECTS

 Investment Projects
 Features:
 Begins with one or a set of negative Cash Flows, followed by a set of positive
Cash Flows
 CF0 < 0, CF1, CF2,…, CFT > 0
 Financing Projects
 Features:
 Begins with one positive Cash Flow, followed by a set of negative Cash Flows
 CF0 > 0, CF1, CF2,...., CFT < 0
 Right now we will focus in Investment Projects

TÍTULO 4
 CASH FLOWS

 Consider the Statement of Cash Flows

Statement of Cash Flows
Operating Activities
(+) Net Income
(+) Depreciation and Amortization
(−) Changes in Net Working Capital
(=) Cash from Operating activities
Investment Activities
(−) Capital Expenditures
(−) Acquisitions and other investments
(=) Cash from Investing activities
Financing activities
(−) Dividends paid
(−) Interest paid
(+) Changes in share capital
(+) Changes in borrowing
(=) Cash from Financing activities
(=) Change in Cash and Cash equivalents
 CASH FLOWS
 The revenues and expenditures relate
 Definition:
 The difference between revenues
and expenditures associated to an
investment project developed during
a well determined period of time
to:
 Operational features, Investment
features, Tax features
 Do not consider any financing
aspects
 The project will evaluated merely
on the operational merits. Only
later the financing options will be
considered
 CASH FLOWS
 So, we will use a simpler version of Cash Flows
 Only considers Cash from Operating and Investment Activities
 Will not consider the Net Income in the beginning
 Because it is affected by interest payments, which are the result of financing
decisions
 We will replace it by the after tax EBIT
 Also known as NOPLAT (Net Operating Profit Less Adjusted Profits)
 CASH FLOWS

 We have the Free Cash Flows of the Project

Free Cash Flow of the Project

Operating Activities
(+) EBIT*(1 – tax rate) = NOPLAT
(+) Depreciation and Amortization
(−) Changes in Net Working Capital
(=) Cash from Operating activities
Investment Activities
(−) Capital Expenditures
(−) Acquisitions and other investments
(=) Cash from Investing activities
(=) Free Cash Flow of the Project
 IMPLEMENTING: THE APPROACH

 Context:
 As an isolated project?
or
 As a non isolated project?
 As part of the firm´s activity, operating together with the other projects the firm
is pursuing
 As one of the possible alternative use of resources
 IMPLEMENTING: THE APPROACH

 As a non isolated project:

 We need to consider the impact the project will have on the firm as a whole
 For example, if the project has a loss (negative EBIT) this will cause a negative
tax instead of zero tax because it reduces the firm’s taxable income

TÍTULO 10
 INCREMENTAL APPROACH

 Consider:  Incremental Perspective

 Only the actions directly caused by 1. Sunk Costs
the project and that can be
2. Opportunity Costs
reversible or can be cancelled if the
project does not go ahead 3. Allocated Costs
4. Side Effects
5. Project time span
 INCREMENTAL APPROACH

 We should not consider:  We should consider:

 Sunk Costs  Opportunity Costs
 Allocated Costs  Side effects
 Releasing assets at the end
 INCREMENTAL APPROACH

 Sunk costs:
 All costs, that although associated with the project, either already happened or
cannot be cancelled or reversed

 Example: costs associated with market research that was already conducted or
paid for
 INCREMENTAL APPROACH

 Allocated Costs
 Allocated costs according to internal accounting rules, but are not an increase in
total costs to the firm
 Example:
 Consider a firm that allocates an equal amount of their security costs to each
project.
 If the firm starts a new project, some of those costs will be allocated to it, but do
not correspond to an increase in costs
 Because the costs we allocate to the project will be removed from the other
projects the firm already has
 INCREMENTAL APPROACH

 Opportunity Costs
 Alternative uses of a resource of the costs caused by using something in a different
way as before
 Example:
 If the project uses land, otherwise vacant, the project prevents the firm to sell or
rent this land
 If the project uses an asset currently being used for something else, it must
account for its replacement
 INCREMENTAL APPROACH
 Side Effects
 Common for firms with many projects with some degree of complementarity or
substitutability

 Cannibalism:
 This project will hurt the sales of another project. The loss in sales must be
considered as a cost
 Sinergy:
 This project increases the sales of another project. The gain in sales must be
considered as income
 EXAMPLE

 Home Builder Supply, a retailer in the home improvement industry, currently

operates seven retail outlets in Georgia and South Carolina. Management is
contemplating building an eighth retail store across town from its most successful
retail outlet.
 The company already owns the land for this store, which currently has an
abandoned warehouse located on it.
 Last month, the marketing department spent $10,000 on market research to
determine the extent of costumer demand for the new store.
 Now Home Builder Supply must decide whether to build and open the new store.

TÍTULO 17
 EXAMPLE
 Which of the following should be considered as part of the incremental earnings for
the proposed new retail store?
 The cost of the land where the store will be located
 The cost of demolishing the abandoned warehouse and clearing the lot
 The loss of sales in the existing retail outlet, if costumers who previously drove
across town to shop at the existing outlet become costumers of the new outlet
 The $10,000 in market research spent to evaluate costumer demand
 Construction costs for the new store
 The value of the land if sold
 Interest expense on the debt borrowed to pay construction costs
 EXAMPLE
 Which of the following should be considered as part of the incremental earnings for
the proposed new retail store?
 The cost of the land where the store will be located
 The cost of demolishing the abandoned warehouse and clearing the lot
 The loss of sales in the existing retail outlet, if costumers who previously drove
across town to shop at the existing outlet become costumers of the new outlet
 The $10,000 in market research spent to evaluate costumer demand
 Construction costs for the new store
 The value of the land if sold
 Interest expense on the debt borrowed to pay construction costs
 FINISHING ELEMENTS
 When the project end we need to:
1. Sell the fixed assets used in the project
2. End the Net Working Capital requirements
 This is called the residual value of the project

 With respect to the Net Working Capital requirements:

 Just set them back to zero when the project is over
 These items will be placed in the project’s last period or in the period after.
 FINISHING ELEMENTS
 Selling the assets
 Use the re-sale price
 Determining the Book Value of the asset when the project is over:
 The difference between purchasing price and accumulated depreciation
 Example:
 Firm XYZ bought an asset, to use in a project. It bought it for 1,000,000. When the
project is over it plans to sell it for 100,000. By then the book value is zero.
 t = 5: CF5= $100,000 – ($100,000 – 0)*0.40 = $60,000
 Rule:
 Cash Flow of Sale: Selling Price – (Selling Price – Book Value)*tax rate
 EXAMPLE
 Cisco is considering the lauch of a new
wireless router model. The projections  Annual sales $26 million
are:
 Annual cost of sales $11 million
 Immediate Administrative and
 Annual fixed costs $2.8 million
Marketing costs of $15 million
 Tax rate 40%
 Spend $7.5 million in new
equipment  4 year project
 Economic life of 5 years and will be
depreciated in constant shares
 The equipment will be sold at the
end of the project for $1 million
 EXAMPLE
 Putting the information together in order to determine the incremental NOPLAT

0 1 2 3 4
+ Sales 26,000 26,000 26,000 26,000
- Cost of Sales 11,000 11,000 11,000 11,000
- Fixed Costs 15,000 2,800 2,800 2,800 2,800
- Depreciation 1,500 1,500 1,500 1,500
= EBIT -15,000 10,700 10,700 10,700 10,700
- Taxes -6,000 4,280 4,280 4,280 4,280
= NOPLAT -9,000 6,420 6,420 6,420 6,420
+ Depreciation 1,500 1,500 1,500 1,500
= Cash Flow -9,000 7,920 7,920 7,920 7,920
 EXAMPLE
 There is a Capital Expenditure in $7.5
million
 Selling at the end for 1 million.
 By then the Book Value is 1.5 million  Will be sold for a loss of 0.5 million
 The annual depreciation was 1.5 m leading to a tax saving in 0.2 million
 The firm used it for 4 year  Cash Flow from the sale: 1 million +
0.2 million = 1.2 million
 The accumulated depreciation was
6 m.
 Book Value when the project was
over
 7.5 m. – 6 m. = 1.5 m.
 EXAMPLE
 Lets include these calculations in the previous Cash Flows table

0 1 2 3 4
+ Sales 26,000 26,000 26,000 26,000
- Cost of Sales 11,000 11,000 11,000 11,000
- Fixed Costs 15,000 2,800 2,800 2,800 2,800
- Depreciation 1,500 1,500 1,500 1,500
= EBIT -15,000 10,700 10,700 10,700 10,700
- Taxes -6,000 4,280 4,280 4,280 4,280
= NOPLAT -9,000 6,420 6,420 6,420 6,420
+ Depreciation 1,500 1,500 1,500 1,500
- CAPEX 7,500
+ Sale of Fixed Assets 1,200
= Cash Flow -16,500 7,920 7,920 7,920 9,120
 EXAMPLE
 Information regarding Net Working Capital:
 Accounts Receivables are 15% of Sales
 Accounts Payable are 15% of Cost of Sales
 The project will cause no change in inventory or cash reserves
 The previous router models have the same structure
 These Net Working Capital goes back to zero at the end of the project (t=4)
0 1 2 3 4 Final
Sales 0 26,000 26,000 26,000 26,000 0
Cost of Sales 0 11,000 11,000 11,000 11,000 0
Acc. Receivables (15%*Sales) 0 3,900 3,900 3,900 3,900 0
Acc. Payable (15%*Cost of Sales) 0 1,650 1,650 1,650 1,650 0
Net Working Capital 0 2,250 2,250 2,250 2,250 0
Change n.a. 2,250 0 0 0 -2,250
 EXAMPLE
0 1 2 3 4
+ Sales 26,000 26,000 26,000 26,000
- Cost of Sales 11,000 11,000 11,000 11,000
- Fixed Costs 15,000 2,800 2,800 2,800 2,800
- Depreciation 1,500 1,500 1,500 1,500
= EBIT -15,000 10,700 10,700 10,700 10,700
- Taxes -6,000 4,280 4,280 4,280 4,280
= NOPLAT -9,000 6,420 6,420 6,420 6,420
+ Depreciation 1,500 1,500 1,500 1,500
- CAPEX 7,500
+ Sale of Fixed Assets 1,200
- Δ Net Working Capital 2,250 0 0 0
+ End of Net Work. Cap. 2,250
= Cash Flow -16,500 5,670 7,920 7,920 11,370
 METHODS USED TO MAKE A DECISION

1. Net Present Value (NPV)

2. Internal Rate of Return (IRR)
3. Profitability Index (PI)
4. Payback Period (PP)
 NET PRESENT VALUE (NPV)

 The sum of the present value of all Cash Flows of the project
 The name comes from the fact that we are getting the present value of the cash
flows, net of the investment
 What it means:
 How much money will the firm get beyond the money it needs to adequately
pay investors at their desired rate of return
 Decision rule:
 NPV ≥ 0: accept
 NPV < 0: reject
 DISCOUNT RATE

 Interpretation:
 It is the opportunity cost of the funds used in the project
 We determine it by reflecting the adequate risk of the project

 Important!
 Do not consider the actual cost of financing, if it happens to be different
 This will only means that the firm was also able to make money in the way it
decided to finance the project, but it should not impact the operating evaluation
of the project
 NET PRESENT VALUE (NPV)

 The NPV of the Cisco project considering a 12% discount rate

5,670 7,920 7,920 11,370

NPV  16,500    
1.12 (1.12) (1.12) (1.12)4
2 3

 NPV = -$16,500 + $5,062.50+ $6,313.78 + $5,637.30 + $7,225.84 = $7,739.42 (>0)

 Decision: accept the project

 INTERNAL RATE OF RETURN (IRR)

 Determine the discount rate that would make the NPV equal to zero
 Solve the equation
T
CFi
 I0   0
t 1 (1  r )
i

 Numerically hard to solve:

 Need a spreadsheet or a financial calculator
 What it means:
 What is the return on the project
 INTERNAL RATE OF RETURN (IRR)

 It is possible to determine a linear approximation to the IRR

 Using linear interpolation, with a disocunt rate that makes NPV >0 and another
that makers NPV<0

 rA: rate with NPV >0; rB: rate with NPV<0

 INTERNAL RATE OF RETURN (IRR)

 Decision
 Compare IRR with project’s discount rate
 IRR ≥ r: accept
 IRR < r: reject

 Cisco example:
 IRR = 30.43% (>12%): accept
 PROFITABILITY INDEX (PI)

 Determines if there was a financial surplus from the investment

 If in present value, the cash flows are larger than the investment
T
CFi
 General formula:
 (1  r )i
VAL
PI  T
i 1
1 T
Ii Ii
i 1 (1  r )i i 1 (1  r )i

 Common situation: T
CFi
 (1  r )i
VAL
PI  i 1
1
I0 I0
 PROFITABILITY INDEX (PI)
 This method is most useful in order to select a subset of projects from a greater set,
with resource constraints, given it identifies the more valuable given one unit of
resources used
 Decision:
 If the investment generates a greater present value of cash flows, accept the
project
 PI ≥ 1: accept the project
 PI < 1: reject the project
 CISCO Example:
 PI = (5, 062.50+ 6,313.78 + 5,637.30 +7,225.84)/16,500 = 1.47 (>1): accept
 PAYBACK PERIOD (PP)

 How long do we need to recover the initial investment

 Use a time limit (n periods)
 Usually the length of the project but could be another arbitrary time period

 Decision:
 PP ≤ n: accept the project
 PP > n: reject the project
 PAYBACK PERIOD (PP)

 To determine the exact moment the payback happens, we use the following formula:

 t is the last period in which the Cash Flow’s accumulated Net Present Value is still
smaller than zero

TÍTULO 38
 PAYBACK PERIOD (PP)

 CISCO Example
 In order to determine the PP, we can build the table below
0 1 2 3 4
CF - 16,500 5,670 7,920 7,920 11,370
PV(CF) -16,500 5,062.50 6,313.78 5,637.30 7,225.84
PV( Acum.CF) -11,437.50 -5,123.72 513,58 7,739.42

 PP happens during the third year (t between 2 and 3)

 Using an linear interpolation method we determine that PP = 2.91 (< 4): accept
the project
5.123.72
PP  2   2.91
5,637.30 TÍTULO 39
 COMPARING THE RESULTS

 They all mean the same

 The 4 methods give the same
recommendation:  NPV > 0 means IRR > r
 Accept the project  NPV > 0 means PI > 1
 NPV@12% = 7,739.42  NPV > 0 means PP < T
 IRR = 30.43%  However:
 PI = 1.47  They have relative advantages and
disadvantages in their
 PP = 2.91
implementation and interpretation
 DECISION RULE

 Net Present Value  Profitability Index

 NPV > 0, yes  PI > 1, yes
 NPV < 0, no  PI < 1, no

 Internal Rate of Return  Payback Period

 IRR > r, yes  PP < T, yes
 IRR < r, no  PP > T, no
 MUTUALLY EXCLUSIVE PROJECTS

 Net Present Value  Profitability Index

 Choose the one with greatest NPV as  Choose the one with greatest PI as
long as greater than zero long as greater than 1

 Internal Rate of Return  Payback Period

 Choose the one with greatest IRR as  Choose the one with smallest PP, as
long as greater than r long as smaller than T