Financial Analysis

1. Financial Analysis Session on Finance Sidharth Sinha Indian Institute of Management, Ahmedabad The views expressed here are those of the presenter and do not necessarily reflect the views or policies of the Asian Development Bank (ADB), or its Board of Directors, or the governments they represent.

2. Time Value of Money • Money received today is not the same as money to be received in the future. • Money received today can be invested to earn a return. • Money to be received in the future is also uncertain • Discounting is the process of adjusting the value of money to be received in the future for time value and risk. • The discounted value is called present value.

3. Present Values • Present value of $1 to be received at the end of 1 year if the discount rate is 10% The higher the discount rate, the lower the present value. • The discount rate is the opportunity cost of not having money now. • This is the rate you could have earned if you had the money now instead of later.

4. Present Values • Present value of $1 to be received at the end of 2 years • This is also known as the discount factor for 2 years at 10% The longer the time period to receiving the money, the lower the present value.

5. Present Values • Present value of $1 to be received at the end of t years at a discount rate of 10% • This is also known as the discount factor for t years at 10%

6. Present Values • Present value of $10 to be received at the end of 2 years Present Value = Cash Flow*Discount Factor

7. Present Values Example - • You just bought a new computer for $3,000. The payment terms are 2 years same as cash. If you can earn 8% on your money, how much money should you set aside today in order to make the payment when due in two years?

8. Present Values • PVs can be added together to evaluate multiple cash flows.

9. Present Values • PVs can be added together to evaluate multiple cash flows. • Discount rate is 7.7%

10. $200 $100 Present Value Year 0 100/1.077 200/1.0772 Total = $92.85 = $172.42 = $265.27 Year 0 1 2 Present Values

11. Net Present Values (NPV) Example - • Assume that the cash flows from the construction and sale of an office building is as follows. Given a 5% required rate of return, create a present value worksheet and show the net present value. • When there are both positive and negative cash flows the term Net Present Value is used.

12. Present Values Example (continued) • Assume that the cash flows from the construction and sale of an office building is as follows. Given a 5% required rate of return, create a present value worksheet and show the net present value.

13. +$320,000 -$100,000 -$170,000 = -$170,000 = $95,238 = $290,249 = $25,011 Present Value Year 0 -170,000 -100,000/1.05 320,000/1.052 Total = NPV Year 0 1 2 Present Values Example (continued) • Assume that the cash flows from the construction and sale of an office building is as follows. Given a 5% required rate of return, create a present value worksheet and show the net present value.

14. Internal Rate of Return Example - • You can purchase a machine tool for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment? • Internal Rate of Return is that discount rate which makes the Net Present Value of the cash flows equal to 0.

15. Internal Rate of Return Example (continued) - • You can purchase a machine tool gadget for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?

16. Internal Rate of Return Example - • You can purchase a machine tool for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment? • IRR is that discount rate which makes the NPV equal to 0. • “Break-even” discount rate

17. IRR=28% Internal Rate of Return

18. Net Present Value • Present value of cash flows at 20% discount rate • Since 20% < IRR project has a positive NPV

19. Project Evaluation • Forecast after tax free cash flows • Estimate appropriate discount rate • Calculate net present value (NPV) • Accept if NPV > 0 • Calculate IRR • Accept if IRR > discount rate

20. Expected Free Cash Flow • Profit before interest and tax (PBIT) • - tax • + depreciation • =cash from operations • Working capital investment • Necessary capital expenditure • = Free cash flow • Cash flow available to pay capital providers - equity & debt investors • Cash flows are uncertain - valuation is based on expected cash flows

21. Weighted Average Cost of Capital (WACC) • Weighted average cost of capital (WACC) • = Cost of equity * prop of equity • +Cost of debt * (1-tax rate)*prop of debt • Proportion of equity • = Equity / (Equity + Debt) • Proportion of debt • = Debt / (Equity + Debt) • Cost of debt = interest rate paid on debt

22. Cost of Equity • Dividend yield + capital gains • Dividend yield = % (dividend per share /share price) • Capital gains = % increase in share price • Required return on equity • = risk free rate + risk premium for equity • Costs of debt, equity and WACC depend on the risk of cash flows • Investors require higher rates of return for riskier projects

23. Enhancing Viability • Increase level of expected free cash flow • Increase revenues • Reduce costs • Reduce WACC by reducing risk of cash flows

24. Inflation • Inflation - rate at which prices as a whole are increasing. • Nominal Interest Rate - rate at which money invested grows. • Real Interest Rate - rate at which the purchasing power of an investment increases.

25. Inflation • Approximation Formula • Real int. rate ≈ nominal int. rate - inflation rate

26. 1 + real interest rate = 1 + real interest rate = 1.025 Real interest rate = .025 or 2.5% Approximation = .059 - .033 =.026 or 2.6% 1+.059 1+.033 Inflation Example - • If the interest rate on one year govt. bonds is 5.9% and the inflation rate is 3.3%, what is the real interest rate?

27. Nominal cash flow forecasts take into account changes in prices of cash flows. • Real cash flows assume constant price level.