Financial Management Report

MBA4032021Week4.pdf

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MBA403 FINANCIAL AND ECONOMIC

INTERPRETATION AND COMMUNICATION

Week 4:

INVESTMENT EVALUATION (II)

Week 4:

INVESTMENT EVALUATION (II)

• Time Value of Money

• Opportunity Cost & Discounting

• Investment Evaluation (II)

o Net Present Value

o Cash Flow Forecasting

o Internal Rate of Return

o Cost of Capital

INVESTMENT EVALUATION II How do we choose among a number of alternative investments? Amongst the techniques available to us are:

• Return on Investment

• Payback Period

Today we add:

• Net Present Value

• Internal Rate of Return

INVESTMENT EVALUATION I

• Return on Investment

• Residual Income

• Payback PeriodWHICH OF THE TWO CASH FLOW

PROFILES FOR TILT’S DYSART SOLAR

ENERGY FARM IS PREFERRED?

DISCUSSION

Estimated Annual Cash Flows ($m)

Profile A Profile B

2022 (Year 0) -200 -200

2023 (Year 1) 40 80

2024 (Year 2) 80 80

2025 (Year 3) 85 80

2026 (Year 4) 90 80

2027 (Year 5) 95 70

Both profiles provide the same total cash inflow of $390m over years 1 to 5.

Which one will Tilt’s management select and why?

(HINT: no calculations are required)

TIMING MATTERS

In Workshop 3 we considered a hypothetical cash flow profile for the Tilt Renewables Dysart Solar Energy Farm.

Instead of the original profile presented (Profile A below) management has now received a revised profile (Profile B below).

INVESTMENT EVALUATION I

• Return on Investment

• Residual Income

• Payback PeriodWHICH OF THE TWO CASH FLOW

PROFILES FOR TILT’S DYSART SOLAR

ENERGY FARM IS PREFERRED?

DISCUSSION: Answer

Estimated Annual Cash Flows ($m)

Profile A Profile B

2022 (Year 0) -200 -200

2023 (Year 1) 40 80

2024 (Year 2) 80 80

2025 (Year 3) 85 80

2026 (Year 4) 90 80

2027 (Year 5) 95 70

TIMING MATTERS

Profile B is preferred since returns are brought forward from 2025, 2026 and 2027 into 2023. Additionally, you may have noticed a shorter Payback Period for Profile B as well as more stable inflows, indicating a lower level of risk.

This illustrates the importance of the timing of cashflows – an aspect of investment evaluation captured by the techniques of Net Present Value and Internal Rate of Return.

Time Value of MoneyVIDEO:

https://www.youtube.com/watch?v=nfkqCv3Rd_g

• There is a cost to having funds committed or ‘tied up’. That cost can be represented by the actual cost of those funds (which we discuss later) or by a measure of ‘opportunity cost’ (see box below).

• Opportunity Cost can be represented by the: inflation rate, prevailing interest rate, rate of return on alternative investments, or a subjective ‘required rate of return’.

• We incorporate opportunity cost by ‘discounting’ future values to an equivalent or ‘opportunity cost adjusted’ present value.

Your opportunity cost of attending this Workshop may be 3 hours of income, time with friends or getting fit in the gym (Workshop attendance is worth it, however!)

OPPORTUNITY COST: The benefit of the next best alternative

OPPORTUNITY COST AND DISCOUNTING INVESTMENT

EVALUATION (II)

• Time Value of Money

• Opportunity Cost & Discounting

• Net Present Value

• Cashflow Forecasting

• Internal Rate of Return

• Cost of Capital

• The Net Present Value (NPV) of an investment is the present value of its cashflows: inflows and outflows. We calculate the present value of each year’s cash flow and sum these to arrive at the NPV. We then apply the decision rule below.

• The NPV indicates the value (in today’s dollars) added to the business by undertaking the project.

• Positive NPV projects can be expected to increase market valuations / share prices, thereby enhancing shareholder wealth.

NET PRESENT VALUE - INTRODUCTION

Accept investments with a positive NPV

Reject investments with a negative NPV

An NPV of zero is borderline and may warrant further consideration

NET PRESENT VALUE DECISION RULE:



INVESTMENT EVALUATION (II)

• Time Value of Money

• Opportunity Cost & Discounting

• Net Present Value

• Cashflow Forecasting

• Internal Rate of Return

• Cost of Capital

• We calculate present value by rearranging our Workshop 3 compound rate of return formula (as shown on the LHS below).

The present value of a single future cash flow:

The NPV of a series of future cash flows and an initial outlay:

NET PRESENT VALUE - FORMULAE

PV = FV

(1+r)n

• We calculate Net Present Value (NPV) as the sum of the present values of the cash flows associated with the investment (RHS above).

• The initial cost of the investment, being an outflow, has a negative sign and is usually not discounted (assuming it takes place at Year 0).

• The discount rate in the NPV calculation is generally referred to as the ‘required rate of return’.

NPV = FVn

(1+r)n Σ n

t=0

INVESTMENT EVALUATION (II)

• Time Value of Money

• Opportunity Cost & Discounting

• Net Present Value

• Cashflow Forecasting

• Internal Rate of Return

• Cost of Capital

NET PRESENT VALUE - EXAMPLE

Estimated Annual Cash Flows ($m)

Present Value of Cash Flows ($m)

2022 (Year 0) -200 -200

2023 (Year 1) 40 40 / (1.12)1 = 35.7

2024 (Year 2) 80 80 / (1.12)2 = 63.8

2025 (Year 3) 85 85 / (1.12)3 = 60.5

2026 (Year 4) 90 90 / (1.12)4 = 57.2

2027 (Year 5) 95 95 / (1.12)5 = 53.9

Sum of PV of Cash Inflows 271.1

Net Present Value 71.1

In Workshop 3 we considered a hypothetical cash flow profile for the Tilt Renewables Dysart Solar Energy Farm (Profile A) and calculated the Payback Period.

Below we calculate the NPV (assuming a 12% annual discount rate).

Given a positive NPV of $71.1m, the project satisfies the criteria for acceptance.



INVESTMENT EVALUATION (II)

• Time Value of Money

• Opportunity Cost & Discounting

• Net Present Value

• Cashflow Forecasting

• Internal Rate of Return

• Cost of Capital

FROM THE INFORMATION

PROVIDED, CALCULATE (USING

EXCEL) THE NET PRESENT VALUE FOR CROWN SYDNEY BY CROWN RESORTS

ACTIVITY The Crown Sydney hotel and casino opened in late-2020. The construction cost for the project was estimated at $1,127m (buildsydney.com).

Calculate the NPV of the project in 2020, assuming the following (fictional) cashflows:

• all construction costs were incurred in 2020,

• yearly cash inflows, starting at $32m in 2021 and rising at 3.6% annually through to 2025,

• A $1,560m estimated market value for the development at end-2025, and

• a 9% required rate of return.

(SPREADSHEET HINT: Place the required rate of return in a single cell and reference your discounting formulae to that cell – so you can easily change it later)

NET PRESENT VALUE

Year Time

Annual

Cashflows

Discounted

Cashflows

2020 0 Initial Project Cost -1127.0 -1127.0

2021 1 Annual Cash Inflow 32.0 29.4

2022 2 Annual Cash Inflow 33.2 27.9

2023 3 Annual Cash Inflow 34.3 26.5

2024 4 Annual Cash Inflow 35.6 25.2

2025 5 Annual Cash Inflow 36.9 24.0

5 Estimated Market Value 1560.0 1013.9

Required Rate of Return 9%

NET PRESENT VALUE 19.8

CROWN SYDNEY NET PRESENT VALUE ANALYSIS

FROM THE INFORMATION

PROVIDED, CALCULATE THE NET PRESENT VALUE FOR CROWN SYDNEY BY CROWN RESORTS

ACTIVITY: Answer

NET PRESENT VALUE

Given a positive NPV of $19.8m, the project satisfies the criteria for acceptance.



EXPLORE THE IMPACT OF

CHANGING CASH FLOWS OR THE

DISCOUNT RATE IN NET PRESENT VALUE

CALCULATIONS

What is the relationship between the NPV and discount rate?

Use your spreadsheet to investigate the impact on NPV from changing the required rate of return or discount rate.

How would COVID-19 have impacted Crown’s NPV analysis of Crown Sydney (and are there any potential offsetting elements)?

NET PRESENT VALUE ACTIVITY: Discussion

Australian Financial Review, 3rd February 2020

• Takes account of the time value of money

• Indicates whether an investment will add value

• Considers the cost of capital and the degree of risk in a project – both of which can be factored into the discount rate

NET PRESENT VALUE - ADVANTAGES INVESTMENT EVALUATION (II)

• Time Value of Money

• Opportunity Cost & Discounting

• Net Present Value

• Cashflow Forecasting

• Internal Rate of Return

• Cost of Capital

• The choice of discount rate can be somewhat subjective yet critical to the outcome of the analysis

• Cashflow forecasts are required.

• NPV only indicates whether the project will meet / exceed the required rate of return. It will not provide the actual rate of return. Hence, we may also calculate the Internal Rate of Return.

NET PRESENT VALUE - DISADVANTAGES INVESTMENT EVALUATION (II)

• Time Value of Money

• Opportunity Cost & Discounting

• Net Present Value

• Cashflow Forecasting

• Internal Rate of Return

• Cost of Capital

VIDEO: The Balance Sheet Explained

CASHFLOW FORECASTING

NPV analysis is a powerful tool. As with many quantitative techniques, the quality / accuracy of the output is related to that of the input.

Furthermore, the more distant the cashflows being forecast, the greater are the unknowns and the likelihood of error.

Hence, due care should be taken when forecasting cashflows. The following may assist in arriving at high quality forecasts.

• Use of reputable third-party forecasts (examples: GDP growth / inflation from the RBA or population projections from the ABS).

• Past experience (where previous trends or developments are seen as a valuable guide to the future).

• Vertical comparisons (assessing trends in similar businesses or businesses that have been in similar situations previously).

• Sophisticated quantitative or econometric techniques

• Scenario Analysis, which we now turn to.

INVESTMENT EVALUATION (II)

• Time Value of Money

• Opportunity Cost & Discounting

• Net Present Value

• Cashflow Forecasting

• Internal Rate of Return

• Cost of Capital

VIDEO: The Balance Sheet Explained

SCENARIO ANALYSIS

Given the margin of error around any single forecast, one approach is to quantify possible alternative future paths. Often these take the form of optimistic and pessimistic scenarios.

An attraction of this approach is it’s flexibility. Probabilities can be attached to each scenario, allowing a probability weighted outcome to be determined.

Returning to Crown Sydney, the cashflow profile we modelled may have been the result of the following scenario analysis.

Scenario: Optimistic Pessimistic

Probability

Weighted

Outcome

Description:

2020 vaccine, rapid recovery of

global economic growth and

international travel

Delayed vaccine, ongoing

disruptions to international

travel yet modest recovery

Probability: 40% 60%

Year 1 Cashflow: $50m $20m $32m

Annual Growth: 6.0% 2.0% 3.6%

Value in Year 5: $2,100m $1,200m $1560m

CROWN SYDNEY CASHFLOW SCENARIO ANALYSIS

INVESTMENT EVALUATION (II)

• Time Value of Money

• Opportunity Cost & Discounting

• Net Present Value

• Cashflow Forecasting

• Internal Rate of Return

• Cost of Capital

• An investment’s Internal Rate of Return (IRR) is its expected annual compound rate of return.

• It answers a slightly different question to that addressed by NPV:

Net Present Value: Internal Rate of Return:

INTERNAL RATE OF RETURN

Is the NPV of the investment greater than zero, at our required rate of return?

• The IRR is the discount rate at which the PV of cash inflows equals the initial investment. It is the discount rate that results in an NPV of zero.

• To calculate the IRR, a ‘trial and error’ approach can be taken (using our NPV spreadsheet) or the IRR Excel function can be used.

Is the breakeven discount rate (NPV=0) greater than our required rate of return?

Accept investments with an IRR > required rate or return Reject investments with an IRR < required rate of return An investment is borderline when IRR = required rate of return

IRR DECISION

RULE

INVESTMENT EVALUATION (II)

• Time Value of Money

• Opportunity Cost & Discounting

• Net Present Value

• Cashflow Forecasting

• Internal Rate of Return

• Cost of Capital

CALCULATE THE INTERNAL RATE OF

RETURN FOR CROWN SYDNEY BY CROWN RESORTS

ACTIVITY From our earlier Net Present Value analysis of the Crown Sydney hotel and casino, calculate the Internal Rate of Return.

Does the Crown Sydney Internal Rate of Return exceed the 9% required rate of return?

(HINT: Try progressively higher discount rates until NPV = 0)

NET PRESENT VALUE INTERNAL RATE OF RETURN

Year Time

Annual

Cashflows

Discounted

Cashflows

2020 0 Initial Project Cost -1127.0 -1127.0

2021 1 Annual Cash Inflow 32.0 29.3

2022 2 Annual Cash Inflow 33.2 27.7

2023 3 Annual Cash Inflow 34.3 26.2

2024 4 Annual Cash Inflow 35.6 24.8

2025 5 Annual Cash Inflow 36.9 23.5

5 Estimated Market Value 1560.0 995.5

Required Rate of Return 9.4%

NET PRESENT VALUE 0.0

CROWN SYDNEY INTERNAL RATE OF RETURN ANALYSIS

CALCULATE THE INTERNAL RATE OF

RETURN FOR CROWN SYDNEY BY CROWN RESORTS

ACTIVITY: Answer

With an IRR of 9.4%, versus a required rate of return of 9.0%, the project satisfies the criteria for acceptance.



INTERNAL RATE OF RETURN

INVESTMENT EVALUATION I

• Return on Investment

• Residual Income

• Payback PeriodCALCULATE THE NPV AND IRR FOR

THE DYSART SOLAR ENERGY FARM

CASHFLOW PROFILE A AND B

ACTIVITY

Estimated Annual Cash Flows ($m)

Profile A Profile B

2022 (Year 0) -200 -200

2023 (Year 1) 40 80

2024 (Year 2) 80 80

2025 (Year 3) 85 80

2026 (Year 4) 90 80

2027 (Year 5) 95 70

Returning to the Tilt Renewables Dysart Solar Energy Farm, calculate the NPV and IRR for each of cashflow Profile A and B. Assume an 8% discount rate.

Do the results confirm our earlier assessment in favour of Profile B?

NPV and IRR

INVESTMENT EVALUATION I

• Return on Investment

• Residual Income

• Payback PeriodCALCULATE THE NPV AND IRR FOR

THE DYSART SOLAR ENERGY FARM

CASHFLOW PROFILE A AND B

ACTIVITY: Answers

Estimated Annual Cash Flows ($m)

Profile A Profile B

2022 (Year 0) -200 -200

2023 (Year 1) 40 80

2024 (Year 2) 80 80

2025 (Year 3) 85 80

2026 (Year 4) 90 80

2027 (Year 5) 95 70

NPV 103.9 112.6

IRR 23.9% 27.9%

Returning to the Tilt Renewables Dysart Solar Energy Farm, calculate the NPV and IRR for each of cashflow Profile A and B. Assume an 8% discount rate.

Do the results confirm our earlier assessment in favour of Profile B? Yes

NPV and IRR

• The balance sheet shows the funding sources of a business: debt and equity. Debt and equity funds each have a corresponding cost.

• In the case of debt, the cost is explicitly represented by the interest rate (typically the average interest rate on the business’ borrowings).

• In the case of equity, the cost is not observable but is the return required in order to satisfy shareholders and/or maintain the share price.

• We can combine the cost of debt and the cost of equity into a cost of capital for use as the required rate of return in our NPV or IRR calculations.

COST OF CAPITALINVESTMENT EVALUATION (II)

• Time Value of Money

• Opportunity Cost & Discounting

• Net Present Value

• Cashflow Forecasting

• Internal Rate of Return

• Cost of Capital

• Our combined cost of capital is known as the Weighted Average Cost of Capital (WACC) and is given by the following formula:

WEIGHTED AVERAGE COST OF CAPITAL (WACC)

WACC = (Cost of Debt x Debt Ratio) + (Cost of Equity x Equity Ratio)

• We can arrive at a simple estimate of WACC, as follows. From Workshop 2, the Debt Ratio is Liabilities/Assets and the Equity Ratio equals Equity/Assets. These two ratios should sum to one.

• To calculate the Cost of Equity, a simplified approach is to use the Earnings Yield from Workshop 2 (the inverse of the Price Earnings ratio). Our WACC calculation now becomes:

INVESTMENT EVALUATION (II)

• Time Value of Money

• Opportunity Cost & Discounting

• Net Present Value

• Cashflow Forecasting

• Internal Rate of Return

• Cost of Capital

WACC = (Interest Rate x Debt Ratio) + (Earnings Yield x Equity Ratio)

FROM WOOLWORTHS’

FINANCIAL STATEMENTS IN THE MBA403 RESOURCES CALCULATE THE FY20

WACC

CALCULATION ACTIVITY

Calculate Woolworths’ FY20 Weighted Average Cost of Capital

• Calculate the Debt Ratio and Equity Ratio from Woolworths’ balance sheet

• Assuming an average loan interest rate of 3.6% and a P/E ratio of 44, calculate the WACC

This WACC could be used as the required rate of return in Woolworths’ NPV and IRR calculations when undertaking investment evaluation

FROM WOOLWORTHS’

FINANCIAL STATEMENTS IN THE MBA403 RESOURCES CALCULATE THE FY20

WACC

Calculate Woolworths’ FY20 Weighted Average Cost of Capital

• Calculate the Debt Ratio and Equity Ratio from Woolworths’ balance sheet: 77% and 23%, respectively

• Assuming an average loan interest rate of 3.6% and a P/E ratio of 44, calculate the WACC: (0.77x3.6%)+(0.23x2.3%) = 3.3%

This 3.3% WACC could be used as the required rate of return in Woolworths’ NPV and IRR calculations when undertaking

investment evaluation

CALCULATION ACTIVITY: Answers

INVESTMENT EVALUATION We have seen numerous techniques for investment evaluation (in addition to our ratios from Workshop 2):

• Return on Investment

• Payback Period

• Net Present Value

• Internal Rate of Return

Of these, Net Present Value and Internal Rate of Return are the most widely used.

INVESTMENT EVALUATION Our focus to date has been exclusively financial. Increasingly, however, companies must adopt a broader perspective in business and investment decision making. Amongst the additional factors to consider are:

• corporate reputation considerations,

• alignment with the overall business strategy,

• sustainability and environmental impacts,

• social and community influences, and

• ethical aspects.

These are explored in the next section of the course.

Next Workshop:

NON-FINANCIAL BUSINESS PERFORMANCE