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 FlowDiscount 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
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
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
Internal Rate of Return
18
Net Present Value

• Present value of cash flows at 20 discount rate
• Since 20 lt 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 gt 0
• Calculate IRR
• Accept if IRR gt 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

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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
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.