Lecture 8 : Cost of capital. Financial modeling of a project

1. Lecture8: Cost of capital. Financial modeling of a project www.finint.ase.ro

2. Phases in Financial Modeling of a project • Initial investment cost • Capital structure • Optimal financing alternative • Financing plan. Evaluating the WACC • Evaluating project’s cash flows • Evaluating the financial performance of the project • Sensitivity analysis 8. Break – Even Point Analysis

3. Step 1: Evaluating initial investment Total cost of investment project should include: • Cost with land • Buildings, production facilities; • Capital Equipments • Installment costs • Testing the equipments • Permits, authorizations • Additional infrastructure • Overheads (10%)

4. Evaluating an investment project (example)

5. Step 2: Optimal capital structure Establishing the weights for main financing alternatives: • Credits; • Bonds; • Stocks. Important Note: in project finance debt is considered to be dominant (70%) The factors taken into consideration in establishing optimal capital structure: • Project dimension; • Project’s borrowing capacity; • Taxation level; • Activity sector (services sector it is financed different than construction sector).

6. Optimal capital structure - example

7. Step 3: Optimal financing alternative • This phase supposes to chose among different offers for each financing source (credit, bonds, equities); • Selection is based on the characteristics of each offer (interest rate, reimbursement program, maturity, other facilities); • Criteria used to compare different financing alternatives: • NPV criterion • IRR criterion

8. NPV Criterion • For estimating NPV of a financing alternative we should know: • How it is amortized each financing alternative; • Which will be future cash flows generated by each financing alternative; • From the amortization table we obtain the annuities used in the formula of NPV; • NPV requires a discounting rate (this discounting rate reflects the expectations of investor in terms of interest rate and can be different than the estimation of the banks);

9. NPV Criterion - Interpretation • Interpretation of NPV: indicates how much we should pay over initial credit in present money (NPV is calculated as difference between initial credit and future annuities). • NPV Criteria: Important: In this case we will select credit B (-20.000 RON) because in this case we will pay less than initial credit –Financing alternative with highest NPV is better !!! • How we can estimate NPV when financing alternatives are denominated in different currencies? • One method is to estimate an exchange rate and to transform annuities in same currency; • Another method is to estimate a discount rate for each financing alternative, to calculate NPV and to use initial exchange rate in order to transform NPV in same currency.

10. IRR Criterion • IRR is that k for which NPV is equal with 0: • From this equation we determine IRR: • By successive trials (for different values of k we obtain a positive value of NPV and a negative value of NPV) and than we approximate IRR by using the following formula: • Other solution is to use IRR function from Excel.

11. IRR Criterion - interpretation • IRR interpretation: IRR is the best measure for the cost of capital of each financing alternative; • If we have to choose among different financing alternatives: • We will select the financing alternative with lowest IRR • If we compare financing alternatives denominated in different currencies we should forecast an exchange rate and to use it to transform annuities in the same currency.

12. IRR and NPV Criteria to select optimal financing alternative - conclusions • IRR is more difficult to calculate; • NPV is based on a discount rate that should be estimated by investor; • NPV and IRR cannot be calculated without knowledge about amortization of a financing alternative; • IRR and NPV can be calculated for any financing alternative (credit, leasing, bonds, equities); • When we estimate IRR and NPV for financing alternatives denominated in different currencies we need to estimate an exchange rate.

13. IRR and NPV Criteria to select optimal financing alternative - conclusions • Selection of optimal financing alternative supposes using of both criteria simultaneously; • Initial conditions should be identical. • IRR and NPV Criteria: • Max (NPV): we will select the financing offer with the highest NPV from the list of different financing alternatives; • Min (IRR): we will select the financing offer with the lowest IRR from the list of different financing alternatives.

14. Example: Selecting the optimal financing alternative • A project company obtained the following offers from two different banks regarding a syndicated loan: • Initial exchange rate: 4,5 lei / Euro. Estimated depreciation of leu against Euro is 1% peryear. Discount rate for leu is 14%. • Optimal financing alternative is chosen by using NPV and IRR Criteria

15. Financing plan • Is a synthesis of all financing alternatives involved in project’s financing; • Shows the financing conditions associated to each financing alternative; • Reflects the cost of capital associated to each financing alternative (IRR for all of them); • It is used to determine the cash flows generated by each financing alternative; • It is used to calculate WACC for project financing plan;

16. Financing plan - Example

17. Estimating cost for each financing alternative Weighted average cost of capital: Notice: In this formula, T is taxation level (bonds and loan supposes payments before taxation and equities after taxation of profits).

18. Ei Rm Prima de risc a pieţei Rf βi=1 Beta Optimizing capital structure using CAPM WACC Cost if financing is 100 % equity financing βcompany=1,3 Notice: If WACC is higher than E(Ri) than financing plan requires an optimization

19. Capital structure optimization • Finding other financing alternatives cheaper than the risk level of the project • Negotiating new financing conditions • Canceling different financing facilities (grace period); • Changing capital structure (weights); • New maturities for financing alternatives; • Higher international diversification of financing alternatives; • Concentrarea pe instrumente cu venit fix şi mai puţin pe cele cu venit variabil.

20. Project valuation www.finint.ase.ro

21. Phases in project valuation Step 1: Estimating project incomes Step 2: Estimating project costs Step 3: Income statement projection Step 4: Cash flow projection Step 5: Project valuation based on specific indicators Step 6: Sensitivity Analysis Break – Even Point Analysis

22. Step 1: Estimating project’s income • It is the first step in the financial modeling process; • Incomes generated by the project are estimated based on the following: • Quantity of goods and services sold on the market; • Selling price for this quantity; • Different factors that could influence the quantity of goods and services sold on the market or price; • In case of specific projects one important issue is related to the fact that the prices of the project could be highly regulated.

23. Step 2: Estimating the project’s costs • Costs could be estimated as percentage of Sales or as specific value (especially variable costs); • When expenditures are estimated as specific value could be estimated as cost per unit or aggregate cost for entire production. • Source of information for cost estimation: • Different departments; • Equipments’ providers; • Raw materials’ providers; • External services providers; • Other sources (local administrative, commodities exchanges) • Costs are estimated for a specific period of time (5 years) and for the first year costs should be detailed monthly.

24. Types of expenditures Wages Raw materials expenditures • OBSERVAŢII: • Part of those costs will be direct productive costs and other (administrative costs, rents) will be indirect productive costs • Part of those costs will be fixed costs and other will be variable costs Utilities and other facilities (water supply, gas, electricity) Spare parts, consumables Commercial expenditures (advertising, promotion) External services expenditures Other expenditures (taxation)

25. Expenditure projection

26. Step 3: Income statement and balance sheet projection • For income statement and balance sheet projection we need additional information about: • Increases of capital; • Sells on commercial credit (as percentage of sales); • Buys on commercial credit (as percentage of sales); • Inventories of raw materials (as percentage of sales) • Other current assets and liabilities;

27. Income statement projection

28. Balance sheet projection

29. Step 4: Cash flow projection • Cash flow is different than net profit because it reconsiders the value of fixed assets depreciation; • It is calculated as difference between inflows (incomes from sales for instance) and outflows (expenditures) of the project; • There are three different components of project’s cash flow: • Operating cash flow; • Investment cash flow; • Financing cash flow.

30. Cash flow projection

31. Step 5: Investment project valuation • The indicators used to evaluate the project are the following: • Net present value (NPV); • Internal Rate of Return (IRR); • Recovery Period of Investment (RPI); • Profitability Index (PI).

32. NPV Criterion in Project Valuation • In case of a project NPV has the following formula: • NPV for a project is calculated as difference between initial investment (I) and future cash flows generated by the project. • For estimating NPV we need a cash flow projection for a specific period of time (usually equal with lifetime of the investment, 5 – 10 years); • Discount rate is a sensitive point of the analysis: • Weighted average cost of capital; • 100% Equity financing cost (derived from CAPM); • Return of second best project.

33. IRR criterion in investment project Note: For small values of k, NPV is highly positive and NPV increases as k decreases and vice versa. At a higher k NPV becomes negative. NPV is equal with 0 in a specific point = projects’ IRR NPV IRR = k*for which NPV = 0 Discount rate - k

34. , Modified IRR (MIRR) • Modified IRR (MIRR) is based on the following assumptions:project’s cash flows are reinvested with a return k; • Modified IRR reflects better the profitability of the project than IRR; • Formula of MIRR is:

35. Calculating MIRR using Excel

36. Recovery Period of Investment Criterion • Recovery period of investment expresses the period of time in which the entire investment is recovered from the profit or net income generated by the project. • Formula of recovery period of investment when net income is constant:or Where: • TiRecovery period • Ititotal investment • Phiannual profit, equal in time • VNiannual net income (or net cash flow) • When the profit (or net income) is not equal in time, we will use the formula: or

37. Profitability Index • Measures the profitability index by dividing the present value of future cash flows to the initial investment (equal with initial investment if investment project is constructed in one year and will be discounted if the construction period is higher than 1 year); • Formula for profitability index: • Profitability index should be higher than1 (If not project will be rejected). Profitability index = Project PV / Initial investment

38. Criteria for project evaluation

39. Sensitivity Analysis • Supposes a change in different variables of the project that will change the parameters of the project; • Before running such analysis we should identify the most important risk factors for the project: • Sales volume; • Other variable expenditures (wages, raw materials, external services, materials); • Financing expenditures (interest rate).

40. Sensitivity Analysis

41. Sensitivity Analysis

42. Break – Even Point Analysis • Determines the point from where the project starts to be a profitable one (break – even point); • This analysis completes the sensitivity analysis offering a different perspective on the minimum value of sales from where the project becomes profitable. • The most used break-even methods are: • ACCOUNTING BREAK-EVEN ANALYSIS • NPV BREAK-EVEN ANALYSIS

43. ACCOUNTING BREAK – EVEN ANALYSIS • The accounting break-even point is the level of sales at which profits are zero or, equivalently, at which total revenues equal total costs. • A project generates the following costs: • Fixed costs (independently from the volume of sales): rentals, real estate taxes, administrative costs, fees; • Variable costs: depend on the volume of sales. Example: raw materials costs, wages, external services; • Depreciation of capital equipments: fixed costs depending on the value of fixed assets

44. Accounting break – even point analysis

45. An example of Accounting Break – Even Analysis http://connection.cwru.edu/mbac424/breakeven/BreakEven.html

46. NPV Break – Even Point Analysis

47. NPV Break Even Point Analysis (Example) Setting NPV equal to 0 we obtain the minimum number of units that should be sold on the market (from this quantity the project starts to be a profitable one). Result: 464 units.

48. Operating Leverage Analysis • Measures the dependency of the profitability from the total volume of fixed costs; • When the weight of fixed costs in a project is high, the decrease of sales will have a deeper impact on the profitability of the project (operating leverage effect); • In the development of a project there are few costs that could be considered fixed costs; • Operating leverage is calculated based on the following formula:

49. Operating leverage - example Note: When we consider that in the operating phase of the project is a high risk of economic recession we will increase the weight of variable costs on the project.