Financial Analysis: Tools and Techniques Phần 6 pps

CHAPTER 7 Cash Flows and the Time Value of Money 231

is added the depreciation effect of $16,667. As we’ll see later, introducing a vari￾able pattern of periodic cash flows can significantly influence the analytical re￾sults. Level periodic flows are easiest to deal with, and are generally found in

financial contracts of various kinds, but they are quite rare in the business setting.

Uneven cash flows are more common and they make the analysis a little more

complex—but such patterns can be handled readily for calculation purposes, as

we’ll demonstrate.

Economic Life

The third element, the time period selected for the analysis, is commonly referred

to as the economic life of the investment project. For purposes of investment

analysis, the only relevant time period is the economic life, as distinguished from

the physical life of equipment, or the technological life of a particular process or

service.

Even though a building or a piece of equipment might be perfectly usable

from a physical standpoint, the economic life of the investment is finished if the

market for the product or service has disappeared. Similarly, the economic life of

any given technology or service is bound up with the economics of the market￾place—the best process is useless if the resulting product or service can no longer

be sold. At that point, any resources still usable will have to be repositioned,

which requires another investment decision, or they might be disposed of for their

recovery value. When redeploying such resources into another project, the net

investment for that decision would, of course, be the estimated recovery value

after taxes.

In our simple example, we have assumed a six-year economic life, the

period over which the product manufactured with the equipment will be sold. The

depreciation life used for accounting or tax purposes doesn’t normally reflect an

investment’s true life span, and in this case we’ve only made it equal to the eco￾nomic life for simplicity. As we discussed earlier, such write-offs are based on

standard accounting and tax guidelines, and don’t necessarily represent the in￾vestment’s expected economic usefulness.

Terminal (Residual) Value

At the end of the economic life an assessment has to be made whether any resid￾ual values remain to be recognized. Normally, if one expects a substantial recov￾ery of capital from eventual disposal of assets at the end of the economic life,

these estimated amounts have to be made part of the analysis. Such recoveries can

be proceeds from the sale of facilities and equipment (beyond the minor scrap

value assumed in our example), as well as the release of any working capital as￾sociated with the investment. Also, there are situations in which an ongoing value

of a business, a facility, or a process is expected beyond this specific analysis

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232 Financial Analysis: Tools and Techniques

period chosen. This condition is especially important in valuation analyses, which

we’ll discuss in Chapters 11 and 12. For our simple illustration no terminal value

is assumed, but later we’ll demonstrate the handling of this concept.

Methods of Analysis

We’ve now laid the groundwork for analyzing any normal business investment by

describing the four essential components of the analysis. Our purpose was to focus

on what must be analyzed. We’ll now turn to the question of how this is done—

the methods and criteria of analysis that will help us judge the economics of the

decision.

How do we relate the four basic components—

• Net investment

• Operating cash inflow

• Economic life

• Terminal value

—to determine the project’s attractiveness? First we’ll dispose quickly of some

simplistic methods of analysis, which are merely rules of thumb that intuitively

(but incorrectly) grapple with the trade-off between investment and operating cash

flows. They are the payback and the simple rate of return, both of which are still

used in practice occasionally despite their demonstrable shortcomings.

Our major emphasis will be on the measures employing the time value of

money as discussed earlier, which enable the analyst to assess the trade-offs be￾tween relevant cash flows in equivalent terms, that is, regardless of the timing of

their incidence. Those key measures are net present value, the present value pay￾back, the profitability index, and the internal rate of return (yield), and in addition,

the annualized net present value. We’ll focus on the meaning of these measures,

the relationships between them, and illustrate their use on the basis of simple ex￾amples. In Chapter 8, we’ll discuss the broader context of business investment

analysis, within which these measures play a role as indicators of value creation,

and discuss more complex analytical problems. As part of this broader context,

we’ll also deal with risk analysis, ranges of estimates, simulation, probabilistic

reasoning, and risk-adjusted return standards.

Simple Measures

Payback

This crude rule of thumb directly relates assumed level annual cash inflows from

a project to the net investment required. Using the data from our simplified ex￾ample, the calculation is straightforward:

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CHAPTER 7 Cash Flows and the Time Value of Money 233

Payback    4 years

The result is the number of years required for the original outlay to be re￾paid, answering the question, How long will it be until I get my money back? It’s

a rough test of whether the amount of the investment will be recovered within its

economic life span. Here, payback is achieved in only four years versus the esti￾mated economic life of six years. Recovering the capital is not enough, of course,

because from an economic standpoint, one would hope to earn a return on the

funds while they are invested.

Visualize a savings account in which $100 is deposited, and from which $25

is withdrawn at the end of each year. After four years, the principal will have been

repaid. If the bank statement showed that the account was now depleted, the saver

would properly demand to be paid the 4 or 5 percent interest that should have

been earned every year on the declining balance in the account.

We can illustrate these basics of investment economics in Figure 7–2, where

we’ve shown how both principal repayment and earnings on the outstanding bal￾ance have to be achieved by the cash flow stream over the economic life. We’re

again using the simple $100,000 investment, with a level annual after-tax operat￾ing cash flow. If the company typically earned 10 percent after taxes on its in￾vestments, part of every year’s cash flow would be considered as normal earnings

return, with the remainder used to reduce the outstanding balance.

The first row shows the beginning balance of the investment in every year.

In the second row, normal earnings of 10 percent are calculated on these balances.

In the third row are operating cash flows which, when reduced by the normal

earnings, are applied against the beginning balances of the investment to calculate

every year’s ending balance. The result is an amortization schedule for our simple

investment that extends into the sixth year—requiring about two more years of

$100,000

$25,000

Net investment

Average annual operating cash flow

FIGURE 7–2

Amortization of $100,000 Investment at 10 Percent

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Beginning balance . . . . . $100,000 $85,000 $68,500 $50,350 $30,385 $ 8,424

Normal company

earnings @ 10% . . . . . 10,000 8,500 6,850 5,035 3,039 842

Operating cash inflows

of project . . . . . . . . . . . 25,000 25,000 25,000 25,000 25,000 25,000

Ending balance to

be recovered . . . . . . . . 85,000 68,500 50,350 30,385 8,424 15,734

Simple payback

(4 $25,000) . . . . . . . Year 4

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234 Financial Analysis: Tools and Techniques

annual benefits than the simple payback measure would suggest. If the project

ended in Year 4, an opportunity loss of about $30,400 would be incurred, and in

Year 5, the loss would be about $8,400. Only in Year 6 will the remaining princi￾pal balance have been recovered and an economic gain of about $15,700

achieved. As we’ll see shortly, all modern investment criteria are based on the

basic rationale underlying this example, with some refinements in the precise cal￾culations used.

We can now quickly dispose of the payback measure as an indicator of in￾vestment desirability: It’s insensitive to the economic life span and thus not a

meaningful criterion of earnings power. It’ll give the same “four years plus some￾thing extra” reading on other projects that have similar cash flows but 8- or

10-year economic lives, even though those projects would be clearly superior to

our example. It implicitly assumes level annual operating cash flows, and cannot

properly evaluate projects with rising or declining cash flow patterns—although

these are very common. It cannot accommodate any additional investments made

during the period, or recognize capital recoveries at the end of the economic life.

The only situation where the measure has some applicability is in compar￾ing a series of simple projects with quite similar cash flow patterns, but even then

it is more appropriate to apply the economic techniques that are readily available

on calculators and spreadsheets.

However, it’s possible to make use of a refined concept of payback that is

expressed in economic terms, but this measure requires the discounting process to

arrive at the so-called present value payback. It’s one of the indicators of invest￾ment desirability that build a return requirement into the analysis, and we’ll dis￾cuss it in detail later.

Simple Rate of Return

Again, only passing comments are warranted about this simplistic rule of thumb,

which in fact is the inverse of the basic payback formula. It states the desirability

of an investment in terms of a percentage return on the original outlay. The

method shares all of the shortcomings of the payback, because it again relates

only two of the four critical aspects of any project, net investment and operating

cash flows, and ignores the economic life and any terminal value:

   25%

What this result actually indicates is that $25,000 happens to be 25 percent of

$100,000, because there’s no reference to economic life and no recognition of the

need to amortize the investment. The measure will give the same answer whether

the economic life is 1 year, 10 years, or 100 years. The 25 percent return indicated

here would be economically valid only if the investment provided $25,000 per

year in perpetuity—not a very realistic condition!

$25,000

$100,000

Average annual operating cash flow

Net investment

Return on

investment

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CHAPTER 7 Cash Flows and the Time Value of Money 235

Economic Investment Measures

Earlier, we described business investment analysis as the process of weighing the

economic trade-off between current dollar outlays and future net cash flow bene￾fits that are expected to be obtained over a relevant period of time. This economic

valuation concept applies to all types of investments, whether made by individuals

or businesses. The time value of money is employed as the underlying methodol￾ogy in every case. We’ll use the basic principles of discounting and compounding

discussed earlier to explain and demonstrate the major measures of investment

analysis. These measures utilize such principles to calculate the quantitative basis

for making economic choices among investment propositions.

Net Present Value

The net present value (NPV) measure has become the most commonly used indi￾cator in corporate economic and valuation analysis, and is accepted as the pre￾ferred measure in the widest range of analytical processes. It weighs the cash flow

trade-off among investment outlays, future benefits, and terminal values in equiv￾alent present value terms, and allows the analyst to determine whether the net

balance of these values is favorable or unfavorable—in other words, the size of

the economic trade-off involved relative to an economic return standard. From the

standpoint of creating shareholder value, a positive net present value implies that

the proposal, if implemented and performing as expected, will add value because

of the favorable trade-off of time-adjusted cash inflows over outflows. In contrast,

a negative net present value will destroy value due to an excess of time-adjusted

cash outflows over inflows. As a basic rule one can say the higher the positive

NPV, the better the value creation potential.

To use the tool, a rate of discount representing a normal expected rate of re￾turn first must be specified as the standard to be met. As we’ll see, this rate is

commonly based on a company’s weighted average cost of capital, which em￾bodies the return expectations of both equity and debt providers of the company’s

capital structure, as described in Chapter 9. Next, the inflows and outflows over

the economic life of the investment proposal are specified and discounted at this

return standard. Finally, the present values of all inflows (positive amounts) and

outflows (negative amounts) are summed. The difference between these sums rep￾resents the net present value. NPV can be positive, zero, or negative, depending

on whether there is a net inflow, a matching of cash flows, or a net outflow over

the economic life of the project.

Used as a standard of comparison, the measure indicates whether an invest￾ment, over its economic life, will achieve the expected return standard applied in

the calculation, given that the underlying estimates are in fact realized. Inasmuch

as present value results depend on both timing of the cash flows and the level of

the required rate of return standard, a positive net present value indicates that the

cash flows expected to be generated by the investment over its economic life will:

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