Financial Management Report

MBA4032021Week3.pdf

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MBA403 FINANCIAL AND ECONOMIC

INTERPRETATION AND COMMUNICATION

Week 3:

DATA & INVESTMENT EVALUATION (I)

Week 3:

DATA & INVESTMENT

EVALUATION (I)

• Data Analysis Exercise

• Rate of Return

• Investment Evaluation (I)

o Return on Investment

o Payback Period

EXTENDED ACTIVITY

• Data drives informed decisions. Through this task, students will analyse how sales in key sectors of the economy performed during the COVID-induced recession.

• Such data would help managers assessing business performance and market share or those considering expansion, investment or new business ventures.

• The exercise requires a device loaded with Excel (or similar) and a working knowledge of Excel.

DATA GATHERING, ANALYSIS & PRESENTATION

“What gets measured, gets managed”

(Peter Drucker, Management Author and Educator)

EXTENDED ACTIVITY

STEP ONE: DATA GATHERING

• Go to the Australian Bureau of Statistics: abs.gov.au

• Navigate to: Statistics

Economy, Business indicators

Business Indicators, Australia

Data downloads

• Download Table 6 – Income from Sales of Goods and Services (current prices)

DATA GATHERING, ANALYSIS & PRESENTATION

Sales During the COVID Recession

EXTENDED ACTIVITY

STEP TWO: DATA ANALYSIS

• Choose a business sector from the 16 sectors in the spreadsheet (excluding Wholesale trade).

• Go to the Seasonally Adjusted time series data for the sector and either save this sheet or copy the data to a new sheet.

Note: seasonal adjustment removes regular seasonal patterns from a series in order to more clearly see the underlying movements in the data.

• Next to your series create and calculate an Annual Percent Change column.

Note: for quarterly data, the annual percent change equals (Datat/Datat-4 - 1)*100

DATA GATHERING, ANALYSIS & PRESENTATION

Sales During the COVID Recession

EXTENDED ACTIVITY

DATA GATHERING, ANALYSIS & PRESENTATION

STEP THREE: PRESENTATION AND INSIGHTS

• Construct two charts covering the past 3 years of data:

- Chart One is your sector data in levels form (your seasonally adjusted time series)

- Chart Two is your sector data in annual percent change form (your calculated series)

• Answer the following questions:

- What was the percentage fall in sales in the first 6 months of 2020 (the height of the COVID recession)?

- Is your chosen sector recovering or still deteriorating?

Sales During the COVID Recession

EXTENDED ACTIVITY

DATA GATHERING, ANALYSIS & PRESENTATION

SAMPLE CHARTS:

WHOLESALE TRADE

• Chart One shows Wholesale Trade sales in levels (that is, the actual value)

• Chart Two shows Wholesale Trade annual percent change terms. This facilitates an assessment of the rate of growth

• All charts should be fully labelled with the data source acknowledged

VIDEO: The Balance Sheet Explained

RATE OF RETURN

• We’ve calculated Return on Sales and Return on Equity. We’ve also constructed an annual percent change series. Each have involved calculating the percentage rate of return for a single year.

• However, we often want to know the rate of return over a longer (or perhaps shorter) time period. For example, in answering the following questions:

How has our investment performed since inception?

What has sales growth averaged over the past 3 years?

• To accurately answer these questions we must switch from a simple rate or return to a compound rate of return.

DATA & INVESTMENT EVALUATION (I)

• Rate of Return

• Return on Investment

• Payback Period

VIDEO: The Balance Sheet Explained

COMPOUND RATE OF RETURN

The compound rate of return allows for the fact that as a series or investment grows over time, it earns ‘a return on the return’.

Illustration A: an investment that earns 5% per annum compounded over 2 years earns 10.25% in total.

Illustration B: an investment that accumulates from $100 to $110 over 2 years earns 4.9% per annum compounded.

DATA & INVESTMENT EVALUATION (I)

• Rate of Return

• Return on Investment

• Payback Period

The Balance Sheet Explained

COMPOUND RATE OF RETURN

The following formulae are used to calculate the compound rate of return (or compound annual growth rate).

Formula working towards an end value:

Formula working from an end value:

FV = PV (1+r)n 1/nFV

PV ( ) r = - 1

Where:

FV = future value (or end value)

PV = present value (or initial value)

r = rate of return (divided by 100)

n = the number of compounding years (can include partial years)

WE WILL COME BACK TO THESE FORMULAE

DATA & INVESTMENT EVALUATION (I)

• Rate of Return

• Return on Investment

• Payback Period

FROM THE NETFLIX SHARE PRICE CHART CALCULATE THE 10 YEAR COMPOUND ANNUAL GROWTH

RATE

CALCULATION ACTIVITY

Netflix listed in the US in May 2002 at an initial share price of $15. From the chart below (source: Reuters) showing the price history of Netflix (code: NFLX) calculate the compound rate of return for the 10 years to 2020.

FROM THE NETFLIX SHARE PRICE CHART CALCULATE THE 10 YEAR COMPOUND ANNUAL GROWTH

RATE

ANSWER: 34% PER ANNUM

CALCULATION ACTIVITY: Answer

INVESTMENT EVALUATION I

How do we choose among a number of alternative investments? Do we select the one that ..

.. provides the highest return?

.. makes the greatest profit?

.. pays us back fastest?

INVESTMENT EVALUATION I

This week and in Workshop 4 we’ll look at a number of investment evaluation tools (additional to the Investment Ratios seen in Workshop 2)

Each have advantages and disadvantages

In practice, the technique(s) used will depend on the situation

(also referred to as RoI or Return on Assets)

• This is a variant of Return on Equity (seen in Workshop 2) and measures profit as a percentage of the assets used to generate the profit

• In simple form:

• Unlike Return on Equity, we wish to identify not just the return to owners but the profit generated by the assets employed by the company, investment or division

• Like RoE, the appropriate RoI will depend on many factors

• Return on Investment may complement the Investment Ratios seen in Workshop 2 (which utilise market prices)

x 100 PROFIT (EBIT)

TOTAL ASSETS

RETURN ON INVESTMENTDATA & INVESTMENT EVALUATION (I)

• Rate of Return

• Return on Investment

• Payback Period

• RoI can be decomposed into two of our ratios from Workshop 2, in order to give us greater insight into the drivers of return: Return on Sales (profit margin) and Asset Turnover.

• In component form:

• Trends in the components of RoI will help to determine the strategy needed in order to improve RoI.

• If Return on Sales is low, pricing and costs may need to be addressed. If Asset Turnover is low, initiatives may be needed to increase sales or divest of unproductive assets.

RETURN ON INVESTMENT

x PROFIT (EBIT)

SALES

RETURN ON SALES x ASSET TURNOVER

SALES

TOTAL ASSETS

DATA & INVESTMENT EVALUATION (I)

• Rate of Return

• Return on Investment

• Payback Period

GO TO THE WOOLWORTHS AND

CSL FINANCIAL STATEMENTS IN THE MBA403 RESOURCES

TO CALCULATE RETURN ON

INVESTMENT AND ITS COMPONENTS

CALCULATION AND DISCUSSION

• CSL is an Australian-based leading global biotech company delivering innovative biotherapies and vaccines.

• For Woolworths and CSL calculate the FY20 Return on Investment and its components.

• What insights do you gain about the two different business models?

• RoI is expressed as a percentage and is, therefore, well suited to comparing businesses of different sizes, including different divisions of the same company.

• RoI is widely used in practice.

• RoI encourages managers to focus on both profits and the assets required to generate those profits.

• The components of RoI help to determine the appropriate strategies for the improvement of RoI.

RETURN ON INVESTMENT - ADVANTAGESDATA & INVESTMENT EVALUATION (I)

• Rate of Return

• Return on Investment

• Payback Period

• As with many financial metrics, improving RoI in the short term may come at the cost of long term sustainable performance.

• Managers may defer necessary asset replacement in order to maintain or improve RoI.

• A focus on RoI may discourage managers from making investments which are profitable (or above the company’s ‘required rate of return’) if they reduce the overall RoI of the business.

RETURN ON INVESTMENT - DISADVANTAGESDATA & INVESTMENT EVALUATION (I)

• Rate of Return

• Return on Investment

• Payback Period

• Calculates how long it takes to pay back the initial cost of an investment, on a cash flow basis.

• The calculation requires an annual profile of cash flows related to the investment.

• The acceptable payback period will vary by investor and is likely to depend upon the perceived risk of the investment.

• The payback period is given by the following formula:

PAYBACK PERIOD

The number of years prior to the year in which the

investment cost is recovered

+ The remaining cash flow to recover / cash flow

during that year x 12 months

DATA & INVESTMENT EVALUATION (I)

• Rate of Return

• Return on Investment

• Payback Period

• Tilt is currently developing the Dundonnell Wind Farm in NE Victoria. 80 turbines are expected to produce enough clean energy each year to power approximately 245,000 homes.

• The project cost is $560m and it is expected to be operational by 2021. Assuming the following (fictional) cash flow profile, calculate the payback period of the project.

PAYBACK PERIOD - EXAMPLE

• Tilt Renewables (ASX Code: TLT) develops, owns and manages renewable energy (wind and solar) generation assets in Australia and New Zealand.

DATA & INVESTMENT EVALUATION (I)

• Rate of Return

• Return on Investment

• Payback Period

PAYBACK PERIOD - EXAMPLE

Estimated Annual Cash Flows ($m)

Cumulative Cash Flows ($m)

2020 (Year 0) -560 -560

2021 (Year 1) 120 -440

2022 (Year 2) 180 -260

2023 (Year 3) 190 -70

2023 (Year 4) 200 130

2025 (Year 5) 210 340

• Referring back to our formula, 2023 (Year 3) is the year prior to payback, with $70m still to recover

• In the following year, there is $200m cash inflow. $70m / $200m x 12 months = 4.2 months

• The payback period for the Dundonnell Wind Farm, on these numbers is 3 years and 4.2 months (or 3 years and 5 months since the 5th

month is the first full month after which we have been repaid)

DATA & INVESTMENT EVALUATION (I)

• Rate of Return

• Return on Investment

• Payback Period

• Tilt has also received approval for the Dysart Solar Energy Farm in Queensland.

• 360,000 solar panels are expected to power over 36,000 homes and offset 170,000 tonnes of CO2 produced by coal- fired electricity generation annually - equivalent to removing 40,000 cars from the roads.

• The estimated project cost is $200m. Assuming the following (fictional) cash flow profile, calculate the payback period of the project.

PAYBACK PERIODINVESTMENT EVALUATION I

• Return on Investment

• Residual Income

• Payback PeriodCALCULATE THE PAYBACK PERIOD

FOR TILT’S DYSART SOLAR ENERGY

FARM IN QUEENSLAND

ACTIVITY

PAYBACK PERIODINVESTMENT EVALUATION I

• Return on Investment

• Residual Income

• Payback PeriodCALCULATE THE PAYBACK PERIOD

FOR TILT’S DYSART SOLAR ENERGY

FARM IN QUEENSLAND

ACTIVITY Estimated Annual Cash Flows ($m)

Cumulative Cash Flows ($m)

2022 (Year 0) -200

2023 (Year 1) 40

2024 (Year 2) 80

2025 (Year 3) 85

2026 (Year 4) 90

2027 (Year 5) 95

Complete the cash flow table and follow the Payback Period formula

PAYBACK PERIODINVESTMENT EVALUATION I

• Return on Investment

• Residual Income

• Payback PeriodCALCULATE THE PAYBACK PERIOD

FOR TILT’S DYSART SOLAR ENERGY

FARM IN QUEENSLAND

ACTIVITY: Answers Estimated

Annual Cash Flows ($m)

Cumulative Cash Flows ($m)

2022 (Year 0) -200 -200

2023 (Year 1) 40 -160

2024 (Year 2) 80 -80

2025 (Year 3) 85 5

2026 (Year 4) 90 95

2027 (Year 5) 95 190

• 2024 (Year 2) is the year prior to payback, with $80m still to recover

• In 2025 (Year 3), there is $85m cash inflow. $80m / $85m x 12 months = 11.3 months

• The payback period for the Dysart Solar Energy Farm, on these numbers is 2 years and 11.3 months (or 2 years and 12 months since the 12th month is the first full month after which we have been repaid)

If Tilt’s required payback period is 3 years, would this project proceed?

What if the requirement was a stricter 2 years? ?

• Has a multi-period dimension, rather than being restricted to a single year.

• Uses cash flows, which can be more objective than accounting profits.

• Simple to use and understand.

• Can compare payback periods of alternative investments

• Implicitly incorporates investment risk – the longer the payback period the greater the risk (more distant cash flows being inherently more uncertain).

PAYBACK PERIOD - ADVANTAGESDATA & INVESTMENT EVALUATION (I)

• Rate of Return

• Return on Investment

• Payback Period

• Doesn’t fully account for the timing of cash flows – inflows in Year 1, for instance, are seen as equivalent to those in Year 4.

• The choice of acceptable payback period is somewhat arbitrary

• Doesn’t consider cash flows after payback. To illustrate this, consider two investments:

Investment 1 costs $90,000 with subsequent annual cash flows of $30,000. The payback period is, therefore, 3 years.

Investment 2 costs $100,000 with annual cash flows of $25,000 from Year 1 to Year 4, followed by a $100,000 inflow in Year 5.

What is the payback period of Investment 2?

Which investment is preferred on a payback period analysis?

Which is the superior investment, on the information provided?

PAYBACK PERIOD - DISADVANTAGESDATA & INVESTMENT EVALUATION (I)

• Rate of Return

• Return on Investment

• Payback Period

Next Workshop:

INVESTMENT EVALUATION (II)