INVESTMENT PROJECTS EVALUATION

Miguel Carvalho miguel.carvalho@mitportugal.org

Tópicos da apresentação

Present Value

of money

Cash Flow

Investment

Project Valuation

Sensitivity Analisys

Summary

Present value of money

What is preferable, to receive 1.000 € NOW or 1.150 € in 2 years?

Present Value of Money

1.000 €

Discount Rate r = 10%

1.000 x (1+10%) 1.100 €

1.000 x (1+10%)2

1.210 €

0 1 2

1.210 €

1 + 10% 2= 1.000 €

Present Value (PV)

What is preferable, to receive 1.000 € NOW or 1.150 € in 2 years?

Cash-Flow

What is a Cash Flow?

New Ventures – Typical cash In-flows and Out-flows

INVESTORS DEBT

PROJECT

DIVIDENDS

INTERESTS

STATE

TAXES

Investors Banks CASH-FLOW RE-INVEST

Equipments, people sub-contracts, Etc…

Balance Sheet, Profit and Losses and Cash-Flow

Balance Sheet - Present A snapshot of the value of a company in a certain point in time Statement of Assets and Liabilities

Profits and Losses Statement - History Measures and Reports Profit generated during a certain period Profit/Loss is an opinion based on accounting Principles

Cash Flow Statement showing cash generation (inflow) and cash usage (outflow)

Balance Sheet

ASSETS • Tangible • Intangible ACCOUNTS RECEIVABLE CASH AND BANKS ...

ASSETS

SHARE CAPITAL RESERVES RETAINED PROFITS NET PROFIT ...

EQUITY

M/L TERM LIABILITIES CURRENT LIABILITIES ...

LIABILITIES

ASSETS = EQUITY + LIABILITIES

Profit & Losses Statement

Simplified Income Statement

1 Revenues • Sales of Goods and products • Services

2 Operational Costs • Outsourced Services • Labor cost

3 Financial Costs

4 Depreciation

5 = 1 – 2 – 3 – 4 Gross Results

6 Taxes

7 = 5 – 6 Net Results

Depreciation

Depreciation represents an accounting cost but does not represent a cash outlfow => they have impact on the Net Results through the fiscal impact

1.500€

Year 1 Year 2 Year 3 Year 4

500€ 500€ 500€ Depreciation

Project AAAAA (Duration 3 years)

Asset value 1.000€ 1.500€ 500€ 0€

They represent the wear and tear that you give to a determined asset during its lifecycle period

Example: You buy 1 Computer to use In Project AAAAA

Typical Depreciation rate for computers 33,33% 1/33,33% = 3 Years

Tipo de bens (%) Anos

Edifícios e outras construções: Edíficios industriais 5,00% 20 Comerciais e administrativos 2,00% 50 Equipamentos de uso

geral: Oficinas: Carpintarias 12,50% 8

Serralharias 14,28% 7 Máquinas -

ferramentas: Ligeiras 20,00% 5

Pesadas 12,50% 8

Aparelhagem e máquinas electrónicas 20,00% 5

Aparelhos de laboratório e precisão 14,28% 7

Equipamento de escritório (p.e.: fotocopiadoras)

20,00% 5

Mobiliário 12,5% 8 Computadores 33,33% 3 Programas de computador 33,33% 3 Aparelhos telemóveis 20,00% 5 Veículos automóveis: Ligeiros e mistos 25,00% 4 Pesados de passageiros 14,28% 7 Pesados e reboques, de mercadorias 20,00% 5

Depreciation (2)

Decreto Regulamentar nº 25/2009 - Typical depreciation taxes

Cash Flow

Cash Flow = Cash Inflows – Cash Outflows

CASH-FLOW

1 Investments

2 Revenues

3 Operational Costs

4 Financial Costs

5 Depreciation

6 = 2 – 3 – 4 – 5 Gross Results

7 Taxes

8 = 6 – 7 Net Results

9 = - 1 + 8 + 5 CASH-FLOW

Lets stop and think for a while on a possible example

Imagine that you are about to start a new business venture in form of a low-cost gourmet restaurant in Lisbon. To launch your new venture from the searches that you have made you will need to acquire kitchen equipment, furniture, a payment machine and also all the other needed services (electricity, water, etc.) and also the human resources needed. Please think on the following items: • Investments What are the necessary investments we need to make to launch this venture? • Costs What are the different costs that we may incur on this activity. • Revenues What can we do in order to estimate revenues? • Market factors What market factors should we Look at? What can originate an increase or decrease on revenues?

Yearly Cash-Flow Calculation (Example)

YEARS

0 1 2 3 4 5 6 7 8 INVESTMENT (CAPEX) 80.000

REVENUES 263.013 283.801 308.168 329.375 353.064 360.125 363.726 363.726

EXEPENSES 256.155 270.509 287.263 301.923 318.257 322.964 325.365 325.365 Materials 175.342 189.201 205.446 219.583 235.376 240.083 242.484 242.484

Personnel Costs 61.504 61.504 61.504 61.504 61.504 61.504 61.504 61.504 External Services 19.309 19.804 20.314 20.836 21.377 21.377 21.377 21.377

EBITDA (1) 6.858 13.293 20.905 27.452 34.807 37.161 38.361 38.361

DEPRECIATION 14.792 14.792 14.792 13.125 13.125 3.125 3.125 3.125

GROSS RESULT -7.933 -1.499 6.113 14.327 21.682 34.036 35.236 35.236

TAX (2) 23% 0 0 1.406 3.295 4.987 7.828 8.104 8.104

NET RESULTS -7.933 -1.499 4.707 11.032 16.695 26.208 27.132 27.132

CASH-FLOW -80.000 6.858 13.293 19.499 24.157 29.820 29.333 30.257 30.257

(1) EBITDA - Earnings before interest, taxes, depreciation, and amortization (2) Tax – Assuming a simplification that 25% of gross results are taxed

Present value of a Cash Flow

PV

CF0

CF1 CF3

CF4

CF2

PV = - C0 + C1/1+r + C2/(1+r)2 + C3/(1+r)3 + C4/(1+r)4

𝑃𝑉 = −𝐶𝐹0 + 𝐶𝐹𝑖1 + 𝑟 𝑖

𝑛

𝑖=1

Present value of a Cash Flow

Discount rate ( r ) = 10%

Present Value (Year 4) = 𝟐𝟒. 𝟏𝟓𝟕

𝟏 + 𝟏𝟎% 𝟒 = 16.499

𝑉𝐴 = −𝐶𝐹0 + 𝐶𝐹𝑖1 + 𝑟 𝑖

𝑛

𝑖=1

ANOS

0 1 2 3 4 5 6 7 8

CASH FLOW -80.000 6.858 13.293 19.499 24.157 29.820 29.333 30.257 30.257

PV CFi -80.000 6.235 10.986 14.650 16.499 18.516 16.558 15.527 14.115

Accum. Cash Flow -80.000 -73.765 -62.780 -48.130 -31.630 -13.114 3.443 18.970 33.085

NPV 33.085

= 33.085

Evaluation of an Investment Project

What criteria should be met when investing on a certain project

Project Evaluation in 3 steps

• Forecast the expected Cash-Flow (after taxes) released by the project.

• Estimate the opportunity cost of capital – r (it reflects the time value of money and the risk involved).

• Calculate NET PRESENT VALUE, INTERNAL RATE OF RETURN and PAY-BACK PERIOD.

Accept project if:

NET PRESENT VALUE • Accept if NPV > 0 • Reject if NPV < 0

INTERNAL RATE OF RETURN • Accept if IRR > r • Reject if IRR < r

-20.000

-10.000

0

10.000

20.000

30.000

40.000

50.000

Internal Rate of Return

NPV(€)

Discount Rate ( r )

TIR ≈

18,36%

r NPV(€)

8% 43.763

10% 33.085 12% 23.640

14% 15.258

16% 7.797 18% 1.135

20% -4.831 22% -10.189

• IRR represents the maximum return rate of the project. • It is the Discount rate that makes NPV = 0.

ANOS 0 1 2 3 4 5 6 7 8

CASH FLOW -80.000 6.858 13.293 19.499 24.157 29.820 29.333 30.257 30.257

IRR 18,36%

Pay-back time

It is the period of time that takes to recover accumulated discouted cash-flows

Discount rate

𝒓 = 𝟏 + 𝑻𝟏 . 𝟏 + 𝑻𝟐 . 𝟏 + 𝑻𝟑 - 1

T1 – Own Capital cost • A good base can be the utilization of historic values of treasure bonds as they (tipically)

represent a no-risk return rate

T2 – Risk Prize • Quantifies the inherent project (example: the associated risks of a restaurant is different

than that associated to a biodiesal plant) • Depends on the kind of project, market, etc…

T3 – Inflation • Always be coherent while treating inflations

Inflation Constant vs. Current Prices

ANOS

0 1 2 3 4 5 6 7 8

CASH FLOWS -80.000 6.858 13.293 19.499 24.157 29.820 29.333 30.257 30.257

PV Cfi -80.000 6.235 10.986 14.650 16.499 18.516 16.558 15.527 14.115

NPV 33.085

ANOS 0 1 2 3 4 5 6 7 8

CASH FLOWS -80.000 6.995 13.830 20.692 26.148 32.924 33.033 34.756 35.451

PV Cfi -80.000 6.235 10.986 14.650 16.499 18.516 16.558 15.527 14.115

NPV 33.085

CONSTANT PRICES Own Capital Cost– 4,762% Risk Prize – 5% Discount rate – 10,0%

CURRENT PRICES Own Capital Cost– 4,762% Risk prize – 5% Inflation – 2 % Discount rate – 12,2%

𝒓 = 𝟏 + 𝑻𝟏 . 𝟏 + 𝑻𝟐 . 𝟏 + 𝑻𝟑 - 1

Discount rate

Perpetuity or Residual Value

Residual Value (RV)

Accounting value at the end of the project

Perpetuity

Anuidades crescentes e perpétuas Anuidades constantes e perpétuas Anuidades constantes e finitas Anuidades crescentes e finitas

𝑅𝑉 = 𝐶𝐹𝑇+1𝑘𝑛 − 𝑔𝑛

𝑅𝑉 = 𝐶𝐹𝑇+1𝑘𝑛

𝑅𝑉 = 1

𝑘𝑛−

1

𝑘𝑛 1 + 𝑘𝑛𝑛−𝑇 𝐶𝐹𝑇+1

𝑅𝑉 = 1

𝑘𝑛 − 𝑔−

1 + 𝑔1 + 𝑘𝑛

𝑛−𝑇

𝑘𝑛 + 𝑔𝑛𝐶𝐹𝑇+1

K – Cost of Capital G – Cash-Flow growth rate

4 Sensitivity Analysis

What if the revenues are lower than expected?

Δ Invest. (%)

NPV (€)

25% 14.986

20% 18.605 15% 22.225 10% 25.845

5% 29.465 0% 33.085

-5% 36.705

-10% 40.325 -15% 43.808

-20% 47.287 -25% 50.766

NPV(€)

% variation on investment value

What if the Investment is higher than expected?

Sensitivity Analisys

Even with an increase of 25% on the investment needed the project would still be able to demonstrate a positive NPV.

Sensitivity Analisys

NPV(€)

% variation in the ammount of meals served

What if revenues are lower than expected?

Δ Reven. (%)

NPV (€)

10% 78.893

8% 69.928 6% 60.788 4% 51.649

2% 42.509 0% 33.085

-2% 23.586

-4% 14.087 -6% 4.579

-8% -5.275 -10% -15.129

If sales decrease by more than 8% the NPV becomes negative so we may eventually need to look at the sales forecasts with a bit more attention or develop alternative strategies in case this occurs.

Scenario Analysis

You should always prepare a couple of scenarios

Beyond sensitivity analysis that allows the variation of 1 or more variables, you should also create possible project development scenarios to analyze the final outcome if severall variables are changed simultaneously.

PESSIMIST SCENARIO REGULAR SCENARIO OPTIMIST SCENARIO

5 Summary

Main concepts to retain

Cash-Flow forecasts: cautions to have (1)

Depreciation is not a Cash-Flow but it affects taxes. Do not forget investments that are needed along the project life-cycle. Separate investment and financing decisiosn (do the analysis as if the project was totally funded by own capital). Carefully analyse:

1. sunk costs 2. Externalities (the effects that the project may have in the remaining

operations of the company) 3. Opportunity costs. 4. General costs

Do not Forget of the Residual Value of the Project 1. Liquidation Value: it is necessary to estimate the sale of assets from the

project and other additional costs (recuperação do investimento em NOF, poupanças fiscais associadas a menos-valias, etc.)

2. Perpetual growth (or not): Assume that the Cash-Flows will grow at a certain growth rate

Be consistent with the treatment of inflation 1. Analysis at current costs (all cash-flows will include expected

inflation) – use a discount rate at nominal terms.

2. Analysis at constant prices – use a discount rate at real terms.

Cash-Flow forecasts: cautions to have (2)

References

Princípios de Finanças Empresariais, Richard A. Breadley, Stewart C. Myers, McGraw Hill Princípios de Gestão Financeira, H. Caldeira Menezes, Editorial Presença Decisões de investimento - Análise Financeira de Projectos, Isabel Soares, José Moreira, João Couto, Edições Sílabo Avaliação de empresas e Negócios, João Carvalho das Neves, McGraw Hill

INDUSTRIAL ECOLOGY

INVESTMENT PROJECTS EVALUATION

Miguel Carvalho miguel.carvalho@mitportugal.org

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