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FINANCIAL ANALYSIS

FINANCIAL ANALYSIS. FINANCIAL ANALYSIS. Evaluating Business Expansion Opportunities as Investment Decisions How to Measure Costs and Benefits Theory: Return on and Return of an Investment Decision Rules: Net Present Value. FINANCIAL ANALYSIS.

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FINANCIAL ANALYSIS

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  1. FINANCIAL ANALYSIS

  2. FINANCIAL ANALYSIS Evaluating Business Expansion Opportunities as Investment Decisions • How to Measure Costs and Benefits • Theory: Return on and Return of an Investment • Decision Rules: Net Present Value

  3. FINANCIAL ANALYSIS Question of Whether to Expand a Business is an Investment Decision • Investment Choices include Dividends, Acquisitions or New Products (Extend Line or Add to Mix) • Answer found by Measuring Difference between Opportunity’s Costs and its Benefits

  4. FINANCIAL ANALYSIS What are the “Costs” to be Evaluated in an Investment Decision? • All the Direct and Indirect Expenses of Producing (but not Operating) the Opportunity • They are the Capital Budget

  5. FINANCIAL ANALYSIS What are the “Benefits” to be Evaluated in an Investment Decision? • In Financial Terms, What does Investment Produce? NET FUTURE CASH FLOWS • “Net” Means Difference between Operating Revenues and Expenses

  6. FINANCIAL ANALYSIS How to Convert “Future Cash Flows” into Measure to Compare with “Current Cost?” • Need Quantity that measures “Present” (Current) Value - a Lump-Sum Amount representing Value of all Future Cash Flows • Can then Compare “Present” (Current) Cost with Present Value of Future Cash Flows • Difference = Investment Decision’s Answer

  7. FINANCIAL ANALYSIS Complications of Converting Future Cash Flows into a “Present Value” Future Cash Flows have to do Two things: • Return OF the Investment and… • Return ON the Investment

  8. FINANCIAL ANALYSIS Return of the Investment: Time Issues When will the Investment be Repaid? • Inflation makes Future Dollars worth less than Current Dollars • Unable to Switch to other, possibly more lucrative Opportunities until Investment repaid (“Opportunity Cost”)

  9. FINANCIAL ANALYSIS Return of the Investment: Repayment Risks What Risks affect Whether the Investment will be Repaid? • Adverse Selection: Bad Investment Choice despite Good Management • Moral Hazard: Incompetent Management causes Good Investment to Fail • Environmental Problems

  10. FINANCIAL ANALYSIS Return on the Investment: Questions • How should Investor be Compensated for Bearing Risks of Whether and When the Investment will be Repaid? • Should Investor receive some Additional Amount (a Premium) for Bearing those Risks? • Could this Premium be expressed as a “Rate” that would be used for comparing other Return/Risk Relationships?

  11. FINANCIAL ANALYSIS Return/Risk Relationships • Invest in US Government: $828 invested today will earn $1,000 in 5 Years ($172 “Premium” or 3.8%) • Invest in A-Rated Corporation: $741 invested today will earn $1,000 in 5 years ($259 “Premium” or 6%) • Invest in BA-101 Start-up: Promises to pay $1,000 in 5 Years. How much should be invested today?

  12. FINANCIAL ANALYSIS The Investment Problem • Entrepreneurs forecast (1) Initial Investment Needs (Capital Budget) plus (2) Future Cash Flows (Operating Budget) and… • Investors set “Rate” necessary to Compensate for Risk • How can Entrepreneur know Investment’s Amount will be enough? and… • How can Investor know Future Cash Flows produce necessary Return ON and OF Investment?

  13. FINANCIAL ANALYSIS The Answer to the Investment Problem • Determine Present Value of Future Cash Flows using Investor’s Required Rate • Compare Present Value with Initial Investment Amount (Capital Budget/Start- up Amount) • Difference equals “NET PRESENT VALUE”

  14. FINANCIAL ANALYSIS Decision Rules • If NPV is NEGATIVE (Present Value of Future Cash Flows LESS than Initial Investment), REJECT Opportunity (Value insufficient to justify Capital Outlay) • If NPV is POSITIVE (Present Value of Future Cash Flows GREATER than Initial Investment), APPROVE Opportunity (Value justifies Capital Outlay)

  15. Present Value of a Lump Sum = Present Value Future Value (1 + r)n Where r = Discount Rate and n = Number of Periods

  16. Estimating Net Present Value PV = $8,000 + $12,000 = $6,957 + $9,074 = $16,031 (1 + .15)1 (1 + .15)2 Net Present Value = Present Value - Initial Outlay NPV = PV - I = $16,031 - $15,000 = $1,031 When Net Present Value is Positive, Present Value exceeds Initial Outlay, Project is Financially Feasible

  17. Deriving a Project’s Net Present Value NPV = $2,048,611 - $2,000,000 = $48,611 Exhibit 17.5

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