1.

Fundamentals

Decision Making, Cost Theory, Break

Even Analysis, Financial Statements,
Financial Ratios, Time Value of Money,
Measures of profitability, Comparison
of Alternatives
01 October 2018 Project Evaluation 1
Overview
 1.1 Cost Theory, Break Even
 1.2 Financial Statements
 1.3 Financial Ratios
 1.4 The Concept of Interest
 1.5 Profitability Measures
 1.6 Comparison of investment
alternatives
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You learn by reading the text,
but also by thinking!

01 October 2018 Project Evaluation 3

Decision Making
 Rekognize/Analyze Decision Problem
 Define Goal (What)
 Data Collection
 Identify Alternatives (How)
 Select Criteria(s)
 Assess Risk
 Make Decision/Select best alternative
01 October 2018 Project Evaluation 4
Capital Budgeting Decisions
 Analyze (see previous slide)
 Design (loops always necessary)
 Plan/Market/Finance/Negotiate
 Invest!
 Operate/Manufacture
 => Profit = Economic Sustainability

01 October 2018 Project Evaluation 5

Cost Concepts
 Variable and Fixed Cost
 Net Profit Contribution
 Break Even Analysis
 Economics of Scale
 Average and Marginal Cost
 Sunk Costs and Opportunity Costs

01 October 2018 Project Evaluation 6

Variable and Fixed Costs
Operational Costs Estimates
Case Study Example

Variable Costs:
Raw Materials 1.4 KUSD/ton
Labour Cost 1.2 "
Transportation 0.4 "
Variable Cost Total 3 "

Fixed Costs:
Maintenance 5 MUSD/year
Housing 3 "
Management 9 "
Sales 3 "
Fixed Costs Total 20 "

01 October 2018 Project Evaluation 7

Break Even Analysis
 Net Profit Contribution (to cover Fixed
Cost)
 Price Elasticity
 Optimizing Production
 Annuity of Investment Cost
 Economics of Scale

01 October 2018 Project Evaluation 8

Net Profit Contribution
Variable Costs:
Raw Materials 1.4 KUSD/ton
Labour Cost 1.2 "
Transportation 0.4 "
Variable Cost Total 3 "

Fixed Costs:
Maintenance 5 MUSD/year
Housing 3 "
Management 9 "
Sales 3 "
Fixed Costs Total 20 "

Sales Price: 15 KUSD/ton

Net Profit Contribution 12 "

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 Break Even Example
Break Even Analysis
without investment costs:
Future Sales Price 15 KUSD/ton
Net Profit Contribution 12 "
Break Even Quantity 1.7 Ktons/year

Break Even Analysis

with investment costs:
Annuity of Loans 80 MUSD/year
Profit requirement 40
Fixed Costs incl annuity 140 "
Break Even incl. annuity 12 Ktons/year

01 October 2018 Project Evaluation 10

Break Even Analysis Graphics
MUSD/year
250 Revenue

200 Variable + Fixed Cost

150
Fixed Cost incl. annuity
100

50

2.5 5.0 7.5 10.0 12.5 15.0

Ktons/year

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Economics of Scale

MUSD/year
250 Revenue
Lower fixed Cost but
200 higher Variable Cost
(less automated)
150

100 Variable + Fixed Cost

50 Fixed Cost incl. annuity

2.5 5.0 7.5 10.0 12.5 15.0

Ktons/year

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Massive and mighty!

01 October 2018 Project Evaluation 13

Financing
 Equity (Shareholders Funds)
 Loans:
 Regular
 Annuity
 Bullet
 Baloon
 WACC

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Criteria / Measures
 Return on Investment (/Equity)
 Pay Back Period
 Financial Statements
 NPV, IRR, B/C ....
 Multi Criteria Decision Making
 Risk Factor
 Efficient Frontier (Pareto)
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Financial Statements
 Statement of Earnings/Operating
Statement
 Statement of Cash Flow/Source &
Allocation of Funds
 Balance Sheet
 Financial Ratios (Assets, Debt, Liquidity,
Profitability, Market Value)

01 October 2018 Project Evaluation 16

Operating Statement
 Revenue/Income - Costs
 => EBITDA

 - Depreciation, Inventory Movement,...

 - Interest of Loans

 => Profit before Tax (EBT)

 - Income Tax

 - Dividend

01 =>Net
 October 2018 Profit/Loss
Project Evaluation 17
 Cash Flow

Shareholders

Equity Drawdown Dividend

Government Taxes Interest & Deb t Holders

Repayment

Company Cash Loans Drawdown

Account
Sales
Costs
Customers Suppliers
Investment

Fixed Assets

01 October 2018 Project Evaluation 18

Source&Application of Funds 1
 Profit before Tax (from Op Statem)
 + Depreciation
 => Funds from Operations
 + Loans & Equity Drawdown
 => Funds for Allocation

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Source&Application of Funds 2
 Allocation:
 Investment
 Repayment of Loans
 Paid Taxes
 Paid Dividend
 => Total Allocation of Funds

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Source&Application of Funds 3
 Changes in Net Current Assets:
 Funds – Allocation
 Analysis:
 Changes in Cash Account
 Changes in Debtors
 Changes in Inventory
 Changes in Creditors

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Alternative Cash Flow
 EBITDA
 - Changes in Debtors + Creditors
 => Cash Flow before Tax (Project)
 - Interest & Repayment of Loans
 => Free (Net) Cash Flow (Equity)
 - Paid Dividend
 + Drawdowns – Investment
 => Cash Account Movement
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Balance Sheet
 Assets:  Debt & Capital:
 Current Assets:  Current Liabilities
 Cash Account  Long Term Debt
 Account Receivable  Total Debt
 Inventory  Equity
 Total Current A  Profit & Loss Bal
 Fixed Assets  Total Capital
 => Total Assets  => Debt & Capital

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Financial Ratios
 Debt Management (DR, DSC, LLCR)
 Liquidity (Current Ratios)
 Asset Management (Turnover Ratios)
 Market Value (P/E, Internal Value)
 Profitability (ROI, ROE)

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The Concept of Interest
 Time Value of Money
 Present and Future Value Calculations
 Net Present Value (NPV) of Cash Flow
Series
 Profitability Measures
 Comparison of alternatives

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Time Value of Money
 Amount today is not equal to same
amount after n years
 Many reasons:
 Opportunity to earn interest
 Inflation
 Risk
 Impatience?

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Present and Future Values
 Present Value: P, Future Value: F
 Interest Rate per year: r
 Future Value after 1 year: F = P*(1+r)
 After 2 years: F2 = P*(1+r)*(1+r)
 After n years: Fn = P*(1+r)^n
 Present Value of F: Pn = Fn / (1+r)^n

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Net Present Value of Cash
Flow Series
 Invested Capital is Cash Flow out
 Operations generate Cash Flow in
 Annual cash in/out: An
 Net Present Value:
NPV = Sum(An/(1+r)^n)
 Should be > 0

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NPV Example, Project A:
 Interest rate = 10%
 Invested Capital year 0 : -100 MUSD
 Operations years 1-5 => +30 “
 NPV: Year 0: -100
 year 1: +30/(1+0.1) = 27.3
 year 2: +30/(1+0.1)^2 = 24.8
 etc
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 NPV Example:
Interest
Project A: 10%
Year Cash Flow Present Accum.
n An: Value: NPV
0 -100 -100.0 -100.0
1 30 27.3 -72.7
2 30 24.8 -47.9
3 30 22.5 -25.4
4 30 20.5 -4.9
5 30 18.6 13.7
Sum: 50 13.7
Internal Rate of Return 15.2%

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Profitability Measures
 Net Present Value
 Pay Back Period, discounted
 Annual Worth / Annuity
 Benefit / Cost Ratio
 Internal Rate of Return (IRR)
 Relation of IRR to NPV

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Profitability measures for the
Example
 Pay Back Period undiscounted = 4 years
 Pay Back Period discounted = 5 years
 Annuity of -100 MUSD = 26.4
 Annual Cash Flow in = 30.0
 Annual Net Worth = 3.6
 Benefits = NPV of 30 in 5 years = 113.7
 Cost = 100 Benefit/Cost Ratio = 1.137
(must be > 1)
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Internal Rate of Return
 Definition: The interest rate that results
in a NPV = 0
 Search for r = IRR such that:
 -100 = sum( 30/(1+r)^n)
 Interpretation: Earning 30 MUSD per
year is equivalent of having 100 MUSD
on an account with interest rate of r
 Here IRR = 15.2%
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 Relation of IRR to NPV
Interest Net Present
Rate Value Net Present Value
0% 50.0
60.0
2% 41.4
50.0
4% 33.6
40.0
6% 26.4
30.0
8% 19.8
20.0
10% 13.7
10.0
12% 8.1
0.0
14% 3.0
-10.0
16% -1.8

%
0%

2%

4%

6%

8%
10

12

14

16

18

20
-20.0
18% -6.2
20% -10.3 Interest Rate

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Comparison of investment
alternatives
 Marginal Attractive Rate of Return (MARR)
 Problems with uneven lifetimes
 Incremental Method

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To every problem there exists
a solution!

01 October 2018 Project Evaluation 36

Marginal Attractive Rate of
Return (MARR)
 The lowest acceptable limit for IRR, i.e.
IRR should be > MARR
 MARR is determined by the best
available alternative use of money
 MARR can be IRR of best alternative
investment possibility, or loan interest
of the most expensive loan

01 October 2018 Project Evaluation 37

Problems with uneven
lifetimes
 Determine lifetime (planning horizon)
for each investment alternative
 If uneven, use the shortest lifetime =
Tmin in comparison
 Estimate salvage value for other
alternatives at end of Tmin and add to
the cash flow

01 October 2018 Project Evaluation 38

Incremental Method for
Comparison
 NPV measure: Select highest NPV
 Annual Worth: Same
 Pay Back Period: Not applicable
 IRR and B/C measures: Use incremental
method, i.e. calculate the difference
 Determine if IRRdiff > MARR
 Determine if B/Cdiff > 1
01 October 2018 Project Evaluation 39
Example of Incremental
Method
Interest
Project B: 10%
YearCash Flow Present Accum.
n An: Value: NPV
0 -150 -150.0 -150.0
1 42 38.2 -111.8
2 42 34.7 -77.1
3 42 31.6 -45.6
4 42 28.7 -16.9
5 42 26.1 9.2
Sum: 60 9.2
Internal Rate of Return 12.4%

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Difference B – A => IRR <
MARR, so A is selected
Project B - A : 10%
YearCash Flow Present Accum.
n An: Value: NPV
0 -50 -50.0 -50.0
1 12 10.9 -39.1
2 12 9.9 -29.2
3 12 9.0 -20.2
4 12 8.2 -12.0
5 12 7.5 -4.5
Sum: 10 -4.5
Internal Rate of Return 6.4%
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We can´t always be choosy!

01 October 2018 Project Evaluation 42