1. Fundamentals

1. 1. Fundamentals Decision Making, Cost Theory, Break Even Analysis, Financial Statements, Financial Ratios, Time Value of Money, Measures of profitability, Comparison of Alternatives Profitability Assessment

2. Overview • 1.1 Cost Theory, Break Even • 1.2 Financial Statements • 1.3 Financial Ratios • 1.4 The Concept of Interest • 1.5 Profitability Measures • 1.6 Comparison of investment alternatives Profitability Assessment

3. You learn by reading the text, but also by thinking! Profitability Assessment

4. Decision Making • Rekognize/Analyze Decision Problem • Define Goal (What) • Data Collection • Identify Alternatives (How) • Select Criteria(s) • Assess Risk • Make Decision/Select best alternative Profitability Assessment

5. Capital Budgeting Decisions • Analyze (see previous slide) • Design (loops always necessary) • Plan/Market/Finance/Negotiate • Invest! • Operate/Manufacture • => Profit = Economic Sustainability Profitability Assessment

6. Cost Concepts • Variable and Fixed Cost • Net Profit Contribution • Break Even Analysis • Economics of Scale • Average and Marginal Cost • Sunk Costs and Opportunity Costs Profitability Assessment

7. Variable and Fixed Costs Profitability Assessment

8. Break Even Analysis • Net Profit Contribution (to cover Fixed Cost) • Price Elasticity • Optimizing Production • Annuity of Investment Cost • Economics of Scale Profitability Assessment

9. Net Profit Contribution Profitability Assessment

10. Break Even Example Profitability Assessment

11. Break Even Analysis Graphics Profitability Assessment

12. Economics of Scale Profitability Assessment

13. Massive and mighty! Profitability Assessment

14. Financing • Equity (Shareholders Funds) • Loans: • Regular • Annuity • Bullet • WACC Profitability Assessment

15. Criteria / Measures • Return on Investment (/Equity) • Pay Back Period • Financial Statements • NPV, IRR, B/C .... • Multi Criteria Decision Making • Risk Factor • Efficient Frontier (Pareto) Profitability Assessment

16. Financial Statements • Statement of Earnings/Operating Statement • Statement of Cash Flow/Source & Allocation of Funds • Balance Sheet • Financial Ratios (Assets, Debt, Liquidity, Profitability, Market Value) Profitability Assessment

17. Operating Statement • Revenue/Income - Costs • => EBITDA • - Depreciation, Inventory Movement,... • - Interest of Loans • => Profit before Tax (EBT) • - Income Tax • - Dividend • =>Net Profit/Loss Profitability Assessment

18. Profitability Assessment

19. Source&Application of Funds 1 • Profit before Tax (from Op Statem) • + Depreciation • => Funds from Operations • + Loans & Equity Drawdown • => Funds for Allocation Profitability Assessment

20. Source&Application of Funds 2 • Allocation: • Investment • Repayment of Loans • Paid Taxes • Paid Dividend • => Total Allocation of Funds Profitability Assessment

21. Source&Application of Funds 3 • Changes in Net Current Assets: • Funds – Allocation • Analysis: • Changes in Cash Account • Changes in Debtors • Changes in Inventory • Changes in Creditors Profitability Assessment

22. Alternative Cash Flow • EBITDA • - Changes in Debtors + Creditors • => Cash Flow before Tax (Project) • - Interest & Repayment of Loans • => Free (Net) Cash Flow (Equity) • - Paid Dividend • + Drawdowns – Investment • => Cash Account Movement Profitability Assessment

23. Balance Sheet • Assets: • Current Assets: • Cash Account • Account Receivable • Inventory • Total Current A • Fixed Assets • => Total Assets • Debt & Capital: • Current Liabilities • Long Term Debt • Total Debt • Equity • Profit & Loss Bal • Total Capital • => Debt & Capital Profitability Assessment

24. Financial Ratios • Debt Management (DR, DSC, LLCR) • Liquidity (Current Ratios) • Asset Management (Turnover Ratios) • Market Value (P/E, Internal Value) • Profitability (ROI, ROE) Profitability Assessment

25. The Concept of Interest • Time Value of Money • Present and Future Value Calculations • Net Present Value (NPV) of Cash Flow Series • Profitability Measures • Comparison of alternatives Profitability Assessment

26. Time Value of Money • Amount today is not equal to same amount after n years • Many reasons: • Opportunity to earn interest • Inflation • Risk • Impatience? Profitability Assessment

27. Present and Future Values • Present Value: P, Future Value: F • Interest Rate per year: r • Future Value after 1 year: F = P*(1+r) • After 2 years: F2 = P*(1+r)*(1+r) • After n years: Fn = P*(1+r)^n • Present Value of F: Pn = Fn / (1+r)^n Profitability Assessment

28. Net Present Value of Cash Flow Series • Invested Capital is Cash Flow out • Operations generate Cash Flow in • Annual cash in/out: An • Net Present Value: NPV = Sum(An/(1+r)^n) • Should be > 0 Profitability Assessment

29. NPV Example, Project A: • Interest rate = 10% • Invested Capital year 0 : -100 MUSD • Operations years 1-5 => +30 “ • NPV: Year 0: -100 • year 1: +30/(1+0.1) = 27.3 • year 2: +30/(1+0.1)^2 = 24.8 • etc Profitability Assessment

30. Profitability Assessment

31. Profitability Measures • Net Present Value • Pay Back Period, discounted • Annual Worth / Annuity • Benefit / Cost Ratio • Internal Rate of Return (IRR) • Relation of IRR to NPV Profitability Assessment

32. Profitability measures for the Example • Pay Back Period undiscounted = 4 years • Pay Back Period discounted = 5 years • Annuity of -100 MUSD = 26.4 • Annual Cash Flow in = 30.0 • Annual Net Worth = 3.6 • Benefits = NPV of 30 in 5 years = 113.7 • Cost = 100 Benefit/Cost Ratio = 1.137 (must be > 1) Profitability Assessment

33. Internal Rate of Return • Definition: The interest rate that results in a NPV = 0 • Search for r = IRR such that: • -100 = sum( 30/(1+r)^n) • Interpretation: Earning 30 MUSD per year is equivalent of having 100 MUSD on an account with interest rate of r • Here IRR = 15.2% Profitability Assessment

34. Relation of IRR to NPV Profitability Assessment

35. Comparison of investment alternatives • Marginal Attractive Rate of Return (MARR) • Problems with uneven lifetimes • Incremental Method Profitability Assessment

36. To every problem there exists a solution! Profitability Assessment

37. Marginal Attractive Rate of Return (MARR) • The lowest acceptable limit for IRR, i.e. IRR should be > MARR • MARR is determined by the best available alternative use of money • MARR can be IRR of best alternative investment possibility, or loan interest of the most expensive loan Profitability Assessment

38. Problems with uneven lifetimes • Determine lifetime (planning horizon) for each investment alternative • If uneven, use the shortest lifetime = Tmin in comparison • Estimate salvage value for other alternatives at end of Tmin and add to the cash flow Profitability Assessment

39. Incremental Method for Comparison • NPV measure: Select highest NPV • Annual Worth: Same • Pay Back Period: Not applicable • IRR and B/C measures: Use incremental method, i.e. calculate the difference • Determine if IRRdiff > MARR • Determine if B/Cdiff > 1 Profitability Assessment

40. Example of Incremental Method Profitability Assessment

41. Difference B – A => IRR < MARR, so A is selected Profitability Assessment

42. We can´t always be choosy! Profitability Assessment