Castellanza,
20th October and
3rd November, 2010 FINANCIAL INVESTMENTS ANALYSIS AND EVALUATION. Corporate Finance
Castellanza,
20th October and
3rd November, 2010 FINANCIAL INVESTMENTS ANALYSIS AND EVALUATION. Corporate Finance
* Executive Summary The investment definition and financial value of the time
The Cash-Flow Model
The Present Value notion
Capital Budget Techniques
Present value
A dollar tomorrow is worth less than a dollar today.
Why?
Present consumption preferred to future consumption – to induce people to give up to present consumption you have to offer them more in the future
Monetary inflation – the value of currencies decreases over time
Uncertainty (risk) – if there is a risk associated with an investment in the future, the less the investment will be valued
Discounting and compounding
Discount rate: it is a rate at which present and future cash flows are traded off. It incorporates:
preference for current consumption
expected inflation
the uncertainty in the future cash flows
Discounting converts future cash flows into present cash flows. Cash flows at different points in time cannot be compared and aggregated. All cash flows have to be brought to the same point in time, before comparisons and aggregations are made.
Compounding converts present cash flows into future cash flows.
* An Investment is
a transfer of monetary resources over time,
mainly characterized by
net outflows in the first stage, and
net inflows in the following periods. A Definition:
* F(t) t An example of flows chart: Implementation Useful life
* Current business decision-making;
Capital budgeting;
Investment decisions;
Asset and liability management;
In detail, about Capital budgeting:
To increase productive capacity;
To buy or improve plant and machinery (equipment investments decisions) / To rationalize processes (make or buy decisions);
To develop and strengthen products and services range;
Acquisition strategies. Financial dynamics include…
*
ENTERPRISE
SHARE-HOLDERS
Investment Opportunities (financial activities) Risk/Return Relationship Risk/Return Relationship Other aspects to focus on:
Fiscal policy;
Financial requirement. Capital Budgeting: forces at play Investment Opportunities (real activities)
* Self-Financing (A)
Equity (E)
Debt (D)
The choice among the sources of fonts is based on:
Capital supply;
Enterprise conditions;
Economic effects;
Non-economic effects;
Financial flexibility.
How to finance investments:
*
Scouting among different alternative investments (strategic and commercial perspective);
Evaluation of alternative investments (technical perspective).
Evaluation of the projects according to financial criteria;
Selection of the most profitable projects. The investment analysis: key stages
* In order to efficiently evaluate investments it is important to have clear information about:
Invested capital;
Investment duration;
Costs and revenues connected to the investment;
Cash flow generated by the investment;
Terminal value of invested capital at the end of the investment period;
Risk connected to the investment. Key information for a consistent evaluation
* Investments financial analysis Key drivers:
risk (connected to every investment)
return (the “result” generated by the investment)
time (the investment duration)
Financial value of time
Cost of capital (Fundraising)
Return of capital (Investments)
* Financial value of time Financial value of time is connected to:
risk (it is proportional to the probability that future cash flows will be effectively collected)
flexibility (possibility to reinvest present cash flow)
Temporal distribution of value
* Both the investments are characterized by the same outflows; however, the temporal distribution of the inflows is clearly different. This feature implies the investments different value. F(t) Time 0 1 2 3 4 F(t) Time 0 1 2 3 4 Cash flow temporal distribution
* Executive Summary The investment definition and financial value of the time
The Cash-Flow Model
The Present Value notion
Capital Budget Techniques
* In order to efficiently evaluate investments it is important to focus on 3 key drivers:
The cash flow amount;
The temporal distribution of the cash flows;
Financial value of time. Key drivers for a consistent evaluation
* Relevant cash flows determination Revenues
- Operating expenses
- Depreciations
= Operating income
- Taxes
= Net Earnings
+ Depreciations
± Change in Net Working Capital (NWC)
= Cash flow from operations
- Investments
+ Divestments
= RELEVANT CASH FLOW
* Guidelines for cash flow determination Do not confuse average and marginal returns (focusing only on marginal returns);
To take into account “collateral” effects;
Do not forget to cover the working capital requirement connected to the investment;
Do not consider sunk costs;
To analyze opportunity cost;
To pay attention on common cost apportionment;
To consider the present value of the fiscal benefit connected to amortization.
* Executive Summary The investment definition and financial value of the time
The Cash-Flow Model
The Present Value notion
Capital Budget Techniques
* Present Value (PV) is
the value on a given date of a future amount of money,
discounted to reflect the financial value of time.
where, Ft = cash flow generated by the investment
k = discount rate
1/(1 + k)t = discount factor PV = Ft
(1 + k)t Present Value
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