EMSI Residential Component

Financial Investment Analysis

5 December 2017

Dr. Gül Özerol

CSTM
University of Twente
g.ozerol@utwente.nl

1
Learning Objectives
 Define, distinguish and compare major concepts and tools
that are applicable to projects and organizations

 Interpret and compare financial statements that are

relevant for organizations

 Evaluate the financial decisions made by organizations

2
Outline

Key Concepts
Financial Statements
Time Value of Money
Interest Rates
Risk and Return
Capital Budgeting Decision Models
Cash Flow Estimation
Reflections

3
Definition of Finance

“The art and science of managing wealth”

• Making decisions regarding what assets to buy/sell and

when to buy/sell these assets.

• Main objective: To make individuals and their

businesses better off.

4
Definition of Financial Management

”Activities that create or preserve the economic value of the

assets of an individual, small business, or corporation”

… making sound financial decisions.

5
The Cycle of Money
The process that financial intermediaries assist in the movement
of money, from lenders to borrowers and back again.
Main objective: to make all the participants better off

6
Overview of Finance Areas

Four main interconnected and interrelated areas:

1. Corporate Finance
2. Investments
3. Financial Institutions and Markets
4. International Finance

7
Internal and External Players

External players
• Customers
• Suppliers
• Government
• Creditors

Internal players
All the
departmental
managers and
other employees

8
Corporate Governance and Business Ethics

Corporate governance: How a company conducts its

business and implements controls to ensure proper procedures
and ethical behavior.

Fair competition and ethical behavior: Laws concerning

employee safety, truth in advertising, pollution control, illegal
bribes, issuance and sale of securities, provision of financial
information.

9
Outline
Key Concepts
Financial Statements
Time Value of Money
Interest Rates
Risk and Return
Capital Budgeting Decision Models
Cash Flow Estimation
Reflections

10
Balance Sheet

Represents the assets owned by the company and the claims

against those assets.

 Based on the accounting identity:

Assets  Liabilities + Owners’ Equity

11
Balance sheet example

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Main Sections of the Balance Sheet
1. Cash account
• “How much money you currently have for paying bills
or spending on new items”
2. Working capital accounts
• Current assets – Current liabilities = Net Working Capital
3. Long-term asset accounts
• Plant and equipment; land and buildings
• Gross value – accumulated depreciation = Net value
4. Long-term liabilities (debt) accounts
• Loans maturing in over 1 year
5. Ownership accounts
• Shareholders’ equity
• Retained earnings - accumulated total since inception

13
Income Statement
Shows the expenses and revenues generated by a firm over a past
period, typically a quarter or a year.

• Net income = Revenues – Expenses

• Net income is not the same as cash flow. Three reasons:
• Accrual accounting
• Non-cash expense items - depreciation
• Preference to classify interest expense as part of cash flow
• Operating income: Earnings Before Interest and Taxes (EBIT) =
Revenues – operating expenses
• Taxable income: Earnings before Taxes (EBT) = EBIT – interest
expenses
• Net income: Earnings after Taxes (EAT) = EBT – Tax expense

14
Income Statement example

15
Outline
Key Concepts
Financial Statements
Time Value of Money
Interest Rates
Risk and Return
Capital Budgeting Decision Models
Cash Flow Estimation
Reflections

16
Future Value and Compounding Interest

The value of money at the end of the stated period is called the
future or compound value of that sum of money.

 Determine the attractiveness of alternative investments

 Figure out the effect of inflation on the future cost of assets, such
as a car or a house.

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The Single-Period Scenario

Future Value = Present Value + Present Value x Interest Rate

FV = PV + PV x r, or
FV = PV x (1+r) (“r” should be in decimals)

Example 1: John deposits $200 for a year in an account that

pays 6% per year. How much money will he have at the end of
the year?
FV = $200 + ($200 x .06) = $212
= $200 x (1.06) = $212

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The Multiple-Period Scenario
FV = PV x (1+r)n n: number of of periods
Example 2: If John closes out his account after 3 years, how much
money will he have accumulated? How much of that is the interest-on-
interest component? What about after 10 years?

FV3 = $200(1.06)3 = $200*1.191016 = $238.20,

where, 6% interest per year for 3 years = $200 x.06 x 3=$36
Interest on interest = $238.20 - $200 - $36 =$2.20

FV10 = $200(1.06)10 = $200 x 1.790847 = $358.17

where, 6% interest per year for 10 years = $200 x .06 x 10 = $120
Interest on interest = $358.17 - $200 - $120 = $38.17

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Present Value and Discounting
 Involves discounting the interest that would have been earned over a
given period at a given rate of interest.
 The exact opposite or inverse of calculating the future value of a sum
of money.
 Such calculations are useful for determining today’s price or the value
today of an asset or cash flow that will be received in the future.
 The formula used for determining present value:
PV = FV x 1 / (1+r)n

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The Single-Period Scenario
When calculating the present or discounted value of a future lump sum
to be received one period from today, we are basically deducting the
interest that would have been earned on a sum of money from its future
value at the given rate of interest.
PV = FV/(1+r) since n = 1

Example: If FV = 100; r = 10%; and n =1, what is the PV?

 PV = 100/1.1 = 90.91

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The Multiple-Period Scenario

When multiple periods are involved…

The formula used for determining the PV:
PV = FV x 1/(1+r)n

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One Equation and Four Variables
 Any time value problem involving lump sums - i.e., a single outflow
and a single inflow - requires the use of a single equation consisting of
4 variables i.e. PV, FV, r, n
 If 3 out of 4 variables are given, we can solve the unknown one.
FV = PV x (1+r)n  solving for future value
PV = FV X [1/(1+r)n]  solving for present value
r = [FV/PV]1/n – 1  solving for unknown rate
n = [ln(FV/PV)/ln(1+r)]  solving for number of periods
“ln”: natural logarithm function

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Outline
Key Concepts
Financial Statements
Time Value of Money
Interest Rates
Risk and Return
Capital Budgeting Decision Models
Cash Flow Estimation
Reflections

24
 Annual and Periodic Interest Rates
 Most common rate quoted is the annual percentage rate (APR). It is
the annual rate based on interest being computed once a year.
 Lenders often charge interest on a non-annual basis. In such a case,
the APR is divided by the number of compounding periods per year
(C/Y or “m”) to calculate the periodic interest rate.
For example: APR = 12%; m=12; i%=12%/12= 1%
 The effective annual rate (EAR) is the true rate of return to the lender
and true cost of borrowing to the borrower.
 An EAR, also known as the annual percentage yield (APY) on an
investment, is calculated from a given APR and frequency of
compounding (m) by using the following equation:

m 
 APR 
EAR  1   1
 m 

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Annual and Periodic Interest Rates (continued)

Example 1: Calculating EAR or APY

The First Common Bank has advertised a loan offering:
“We will lend you $100,000 for up to 3 years at an APR of
8.5% (interest compounded monthly).”
If you borrow $100,000 for 1 year, how much interest will you
have paid and what is the bank’s APY?

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Annual and Periodic Interest Rates (continued)

Example: Answer
Nominal annual rate: APR = 8.5%
Frequency of compounding: C/Y = m = 12
Periodic interest rate: APR/m = 8.5%/12 = 0.70833% = .0070833

APY or EAR = (1.0070833)12 - 1 = 1.08839 - 1 =8.839%

Total interest paid after 1 year = 0.08839*$100,000 = $8,839.09

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Effect of Compounding Periods on Time
Value of Money Equations

 TVM equations require the periodic rate (r%) and the number
of periods (n) to be entered as inputs.
 The greater the frequency of payments made per year, the
lower the total amount paid.
More money goes to principal and less interest is charged.
 The interest rate entered should be consistent with the
frequency of compounding and the number of payments
involved.

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Outline

Key Concepts
Financial Statements
Time Value of Money
Interest Rates
Risk and Return
Capital Budgeting Decision Models
Cash Flow Estimation
Reflections

29
Returns

 Performance analysis of an investment requires investors to

measure returns over time.
 Return and risk being intricately related, return measurement
helps in the understanding of investment risk.

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Dollar Profits and Percentage Returns

Dollar Profit or Loss = Ending value

+ Distributions
– Original Cost

Rate of return = Dollar Profit or Loss

Original Cost

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Example: Dollar Profits and Percentage Returns

Question

Joe bought some gold coins for $1000 and sold those 4
months later for $1200.
Jane on the other hand bought 100 shares of a stock for $10
and sold those 2 years later for $12 per share after receiving
$0.50 per share as dividends for the year.

What is the dollar profit and percentage return earned by each

investor?

32
Example: Dollar Profits and Percentage Returns
(continued)

Answer
Joe
Dollar Profit = Ending value – Original cost
= $1200 - $1000 = $200
Percentage Return = Dollar profit / Original cost
= $200 / $1000 = 20%
Jane
Dollar Profit = Ending value + Distributions - Original Cost
= $12*100 + $0.50*100 - $10*100
= $1200 + $50 - $1000 = $250
Percentage Return = $250 / $1000 = 25%

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Risk (Certainty and Uncertainty)

 Future performance of most investments is uncertain.

 Risky  Potential for loss exists

 Risk can be defined as a measure of the uncertainty in a set of

potential outcomes for an event in which there is a chance of
some loss.

 It is important to measure and analyze the risk potential of an

investment, so as to make an informed decision.

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Returns in an Uncertain World
(Expectations and Probabilities)
For future investments we need expected or ex-ante
rather than ex-post return and risk measures.

For ex-ante measures we use probability distributions,

and then the expected return and risk measures are
estimated using the following equations:

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Determining the Probabilities of All Potential Outcomes

When setting up probability distributions, two rules must be followed:

1. The sum of the probabilities must always add up to 1.0 or 100%.
2. Each individual probability estimate must be positive. We cannot
have a negative probability value.

36
The Risk-and-Return Trade-off

 Investments must be analyzed in terms of, both, their return

potential as well as their riskiness or variability.

 Historically, its been proven that higher returns are

accompanied by higher risks.

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Investment Rules

Investment rule number 1: If two investment choices have the same

expected returns, select the one with the lower expected risk.

Investment rule number 2: If two investment choices have similar

risk profiles, select the one with the higher expected return.

To maximize return and minimize risk, it would be ideal to select an

investment that has a higher expected return and a lower expected
risk than the other alternatives.

Realistically, higher expected returns are accompanied by greater

variances and the choice is not that clear cut. The investor’s tolerance
for and attitude towards risk matters.

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Investment Rules (continued)

Minimizing risk:
Rule 1. Asset A is
preferred to asset B
because, for the
same return, there
is less risk.

Maximizing return:
Rule 2. Asset C is
preferred to asset D Which asset, L or S?
because of higher
expected return with
the same risk.

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Diversification:
Minimizing Risk or Uncertainty

Diversification is the spreading of wealth over a variety of

investment opportunities so as to eliminate some risk.

By dividing up one’s investments across many relatively low-

correlated assets, companies, industries, and countries, it is
possible to considerably reduce one’s exposure to risk.

40
Outline
Key Concepts
Financial Statements
Time Value of Money
Interest Rates
Risk and Return
Capital Budgeting Decision Models
Cash Flow Estimation
Reflections

41
Short-Term and Long-Term Decisions

Long-term decisions
1. have longer time horizons,
2. cost larger sums of money, and
3. require a lot more information to be collected as part of their
analysis, than short-term decisions.

! Capital budgeting decisions are often long-term decisions.

42
Capital Budgeting Decisions

1. Typically a go or no-go decision on a product, service, facility, or

activity proposal.
2. Requires sound estimates of the timing and amount of cash flow
for the proposal.
3. The capital budgeting model has a predetermined accept or reject
criterion.

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Payback Period
The length of time in which an investment pays back its original cost.
Decision rule: Payback period < Cutoff period  Accept.
 Main focus is on cost recovery or liquidity.
The method assumes that:
• all cash outflows occur at the beginning of the project’s life
followed by a stream of inflows.
• cash inflows occur uniformly over the year.

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Example: Payback period

The owner of Perfect Images Salon is considering the purchase of a

new tanning bed.
It costs $10,000 and is likely to bring in after-tax cash inflows of
$4,000 in the first year, $4,500 in the second year, $10,000 in the
3rd year, and $8,000 in the 4th year.
The firm has a policy of buying equipment only if the payback period
is 2 years or less.
Calculate the payback period of the tanning bed and state whether
the owner would buy it or not.

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Example: Answer

Percent of Year
Year Cash flow Yet to be recovered
Recovered/Inflow

0 (10,000) (10,000)

-10,000 + 4,000 =
1 4,000
(6,000)
-6,000 + 4500 =
2 4,500
(1,500)
-1,500 + 1,500 =
3 10,000 15%
0 (recovered)
4 8,000 Not used in decision

Payback Period = 2.15 years > 2 years  Decision: Reject

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Major flaws of the payback period method

1. It ignores all cash flow after the initial cash outflow has been
recovered.
2. It ignores the time value of money.
3. It ignores the riskiness of the cash flows.

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Discounted Payback Period
 Calculates the time it takes to recover the initial investment in
current or discounted dollars.
 Incorporates time value of money by adding up the discounted cash
inflows at time 0, using the appropriate hurdle or discount rate, and
then measuring the payback period.
 It is still flawed, since cash flows after the payback are ignored.

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Example: Discounted Payback Period
Calculate the discounted payback period of the tanning bed, stated in
Example 1, by using a discount rate of 10%.

Cash Yet to be Percent of Year

Year Discounted CF
flow recovered Recovered / Inflow

0 (10,000) (10,000) (10,000)

4,000/(1+0.1)1 = -10,000+3,636 =
1 4,000 3,636 (6,364)
4,500/(1+0.1)2 = -6,364+3,719 =
2 4,500 3,719 (2,645)
10,000/(1+0.1)3 = -2,645+7,513 = 2,645/7,513=
3 10,000 7,513 4,869 35%
Not used in
4 8,000 5,464
decision

Discounted Payback = 2.35 years >2 years  Decision: Reject

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Net Present Value (NPV)
Discounts all the cash flows from a project back to time 0 using an
appropriate discount rate, r:

A positive NPV implies that the project is adding value to the firm’s
bottom line  When comparing projects, the higher the NPV the better.

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Example: Calculating NPV
Using the cash flows for the tanning bed and a discount rate of 10%, calculate
its NPV and indicate whether the investment should be undertaken or not.

Year Cash flow

0 (10,000)
1 4,000
2 4,500
3 10,000
4 8,000
Answer
NPV bed = -$10,000 + $4,000/(1.1) + $4,500/(1.1)2 + $10,000/(1.1)3 + $8,000 /(1.1)4
= -$10,000 + $3,636.36 + $3719.01 + $7513.15 + $5,464.11
= $10,332.62
Decision: NPV > 0  The tanning bed should be purchased.

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Internal Rate of Return
The Internal Rate of Return (IRR or r) is the rate which forces the sum of
all the discounted cash flows from a project to equal 0.

The decision rule:

IRR > hurdle rate  NPV > 0  Accept project

IRR is measured as a percent, while the NPV is measured in dollars.

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Example: Calculating IRR

Using the cash flows for the tanning bed, calculate its IRR and state your
decision.
CF0 = -$10,000
CF1 = $4,000
CF2 = $4,500
CF3 = $10,000
CF4 = $8,000
Hurdle rate = 10%

Exercise: Use the IRR function in Excel to make your decision

Answer

IRR = 44.932% > 10%  Accept it!

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Hurdle Rate
Hurdle rate is the minimum acceptable rate of return that should be
earned on a project given its riskiness.

Sometimes, it helps to draw an NPV profile:

• A graph plotting various NPVs for a range of incremental discount
rates, showing at which discount rates the project would be
acceptable and at which rates it would not.

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 Net present value profile of investment A

The point where the NPV line cuts the X-axis is the IRR of the project,
i.e. the discount rate at which the NPV = 0.
 At rates below the IRR, the project has a positive NPV and will be
acceptable and vice-versa.
55
Problems with the Internal Rate of Return

In most cases, NPV decision = IRR decision

• If a project has a positive NPV, its IRR usually exceeds its
hurdle rate, making it acceptable.
• The highest NPV project generally has the highest IRR.
! There are some cases when the IRR method leads to ambiguous
decisions or is problematic. In particular, we can have two problems
with the IRR approach:
1. Multiple IRRs; and
2. An unrealistic reinvestment rate assumption.

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Modified Internal Rate of Return (MIRR)
 Despite several shortcomings, managers like to use IRR since it is
expressed as a % rather than in dollars.
 The MIRR was developed to get around the unrealistic reinvestment
rate criticism of the traditional IRR.
 Under the MIRR, all cash outflows are assumed to be reinvested at
the firm’s cost of capital or hurdle rate, which makes it more realistic.
 We calculate the future value of all positive cash flows at the terminal
year of the project, the present value of the cash outflows at time 0;
using the firm’s hurdle rate; and then solve for the MIRR:

57
Example: Calculating MIRR
Using the cash flows below and a discount rate of 10%; calculate the
MIRRs for Projects A and B. Which project should be accepted? Why?

Year A B (A-B)

0 -10,000 -7,000 -3,000

1 5,000 9000 -4,000

2 7000 5000 2,000

3 9000 2000 7,000

IRR 42.98% 77.79% 12.04%

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Example: Answer

Project A:
PV of cash outflows at time 0 = $10,000
FV of cash inflows at year 3, @10%
= 5,000*(1.1)2 + 7,000*(1.1)1 + 9,000 = 6,050 + 7,700 + 9,000 = $22,750
MIRRA = (22,750/10,000)1/3 – 1 = 31.52%

Project B:
PV of cash outflows at time 0 = $7,000
FV of cash inflows at year 3, @10%
= 9,000*(1.1)2 + 5,000*(1.1)1 + 2,000 = 10,890 + 5,500 + 2,000 = $18,390
MIRRB = (18,390/7,000)1/3 – 1 = 37.98%

Decision: Accept Project B since its MIRR is higher.

59
Profitability Index
If faced with a constrained budget, choose projects that give us the
best value for our money.
The Profitability Index (PI) can be used by calculating the ratio of the
PV of benefits (inflows) to the PV of the cost of a project:

PI tells us how many dollars we are getting per dollar invested.

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Example: PI calculation

Using the cash flows below, and a discount rate of 10%, calculate the
PI of each project. Which one should be selected? Why?

Year A B
0 -10,000 -7,000
1 5,000 9000
2 7000 5000
3 9000 2000

NPV@10% $7,092.41 $6,816.68

Answer
PIA = (NPV + Cost) / Cost = $17,092.41 / $10,000 = 1.71
PIB = (NPV + Cost) / Cost = $13,816.68 / $7,000 = 1.97

Select Project B; higher PI

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 Overview of Six Decision Models
• simple and fast, but economically unsound.
Payback period • ignores all cash flow after the cutoff date.
• ignores the time value of money and riskiness of cash flows.

Discounted • incorporates the time value of money.

payback period • still ignores cash flow after the cutoff date.

• economically sound.
Net present
value (NPV) • properly ranks projects across various sizes, time horizons, and levels of risk,
without exception for all independent projects.

• provides a single measure (return).

Internal rate of • has the potential for errors in ranking projects.
return (IRR) • can lead to an incorrect selection when there are two mutually exclusive
projects, or incorrect acceptance or rejection of a project with multiple IRRs.

Modified • corrects for most of, but not all, the problems of IRR and gives the solution in
internal rate of terms of a return.
return (MIRR) • the reinvestment rate may or may not be appropriate for the future cash flows.

Profitability • incorporates risk and return.

index (PI) • the benefits-to-cost ratio is actually just another way of expressing the NPV.
Comparison of Six Decision Models
Outline
Key Concepts
Financial Statements
Time Value of Money
Interest Rates
Risk and Return
Capital Budgeting Decision Models
Cash Flow Estimation
Reflections

64
The Importance of Cash Flow
Cash flow measures the actual inflow and outflow of cash, while net
income (profits or losses) represent merely an accounting measure of
periodic performance.
A firm can spend its operating cash flow but not its net income.
Some firms have net losses (due to high depreciation write-offs) and yet
can pay dividends from cash balances, while others show profits and
may not have the cash available.
Thus, cash flow is broader than net income.

65
Estimating Cash Flow for Projects:
Incremental Cash Flow
• For expansion, replacement or new project analysis, incremental effects
on revenues and expenses must be considered.
• Careful estimation and evaluation of the timing and magnitude of
incremental cash flows is very important.
• 7 important issues to keep track of:
• sunk costs,
• opportunity cost,
• erosion cost,
• synergy gains,
• working capital,
• capital expenditures, and
• depreciation or cost recovery of assets.

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(A) Sunk costs
Expenses that have already been incurred, or that will be incurred,
regardless of the decision to accept or reject a project.
• For example, a marketing research study exploring business
possibilities in a region would be a sunk cost, since its expenditure
has been done prior to undertaking the project and will have to be
paid whether or not the project is taken on.
• These costs although part of the income statement, should not be
considered as part of the relevant cash flows when evaluating a
capital budgeting proposal.

67
(B) Opportunity costs
Costs that may not be directly observable or obvious, but result from
benefits being lost as a result of taking on a project.
• For example, if a firm decides to use an idle piece of equipment as
part of a new business, the value of the equipment that could be
realized by either selling or leasing it would be a relevant opportunity
cost.
• These costs should be included.

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(C) Erosion costs
Costs that arise when a new product or service competes with
revenue generated by a current product or service offered by a firm.
• For example, if a store offers two types of photo-copying services, a
newer, more expensive choice and an older economical one.
• Some of the revenues from the older repeat customers will be lost
and should therefore be accounted for in the incremental cash flows.

69
(D) Synergy gains
The impulse purchases or sales increases for other existing products
related to the introduction of a new product.
 For example, if a gas station with a convenience store attached, adds
a line of fresh donuts and bagels, the sales of coffee and milk, would
result in synergy gains.

70
(E) Working capital
Additional cash flows arising from changes in current assets such as
inventory and receivables (uses), and current liabilities such as
accounts payables (sources) that occur as a result of a new project.
• Generally, at the end of the project, these additional cash flows are
recovered and must be accordingly shown as cash inflows.
• Even though the net cash outflows -- due to increase in net working
capital at the start -- may equal the net cash inflow arising from the
liquidation of the assets at the end, the time value of money effects
make these costs relevant.

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(F) Capital spending and depreciation
Capital expenditures are allowed to be expensed on an annual basis and can be
used as tax shields. The portion written off in the income statement each year, is
called the Depreciation Expense; and the accumulated total kept track of in the
balance sheet is known as Accumulated Depreciation.
Book value of an asset = Original cost - Accumulated depreciation
Why do we deal with depreciation for capital budgeting problems?
1. the tax flow implications from the operating cash flow
2. the gain or loss at disposal of a capital asset
Firms can use one of the two approaches for allocating the annual depreciation
expense, arising from an asset acquisition:
1. Straight line depreciation: Annual depreciation expense = (Initial cost +
installation - Expected residual value ) / Expected productive life of the asset.
 Annual depreciation expenses are the same for each year.
2. Modified Accelerated Cost Recovery System: Rates are established as a
way to allow for firms to accelerate the depreciation write-off in early years of
the asset’s life.

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Outline

Key Concepts
Financial Statements
Time Value of Money
Interest Rates
Risk and Return
Capital Budgeting Decision Models
Cash Flow Estimation
Reflections

73
Reflections

1. What is the most interesting thing you learned today?

Why?

2. What is the most important issue among those discussed

today? Why?

3. Did we meet the learning objectives?

 Define, distinguish and compare major concepts and tools
that are applicable to projects and organizations
 Interpret and compare financial statements that are relevant
for organizations
 Evaluate the financial decisions made by organizations

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