Download - 1. Fundamentals
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20 April 2023 Profitability Assessment 1
1. Fundamentals
Decision Making, Cost Theory, Break Even Analysis, Financial
Statements, Financial Ratios, Time Value of Money, Measures of profitability, Comparison of
Alternatives
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20 April 2023 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
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20 April 2023 Profitability Assessment 3
You learn by reading the text, but also by thinking!
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Decision Making
Rekognize/Analyze Decision Problem Define Goal (What) Data Collection Identify Alternatives (How) Select Criteria(s) Assess Risk Make Decision/Select best alternative
20 April 2023 Profitability Assessment 4
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Capital Budgeting Decisions
Analyze (see previous slide) Design (loops always necessary) Plan/Market/Finance/Negotiate Invest! Operate/Manufacture => Profit = Economic
Sustainability
20 April 2023 Profitability Assessment 5
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20 April 2023 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
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20 April 2023 Profitability Assessment 7
Variable and Fixed CostsOperational Costs EstimatesCase Study Example
Variable Costs: Raw Materials 1.4 KUSD/tonLabour Cost 1.2 "Transportation 0.4 "Variable Cost Total 3 "
Fixed Costs:Maintenance 5 MUSD/yearHousing 3 "Management 9 "Sales 3 "Fixed Costs Total 20 "
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Break Even Analysis
Net Profit Contribution (to cover Fixed Cost)
Price Elasticity Optimizing Production Annuity of Investment Cost Economics of Scale
20 April 2023 Profitability Assessment 8
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20 April 2023 Profitability Assessment 9
Net Profit ContributionVariable Costs:
Raw Materials 1.4 KUSD/tonLabour Cost 1.2 "Transportation 0.4 "Variable Cost Total 3 "
Fixed Costs:Maintenance 5 MUSD/yearHousing 3 "Management 9 "Sales 3 "Fixed Costs Total 20 "
Sales Price: 15 KUSD/tonNet Profit Contribution 12 "
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20 April 2023 Profitability Assessment 10
Break Even Analysiswithout investment costs:
Future Sales Price 15 KUSD/tonNet Profit Contribution 12 "Break Even Quantity 1.7 Ktons/year
Break Even Analysiswith investment costs:
Annuity of Loans 80 MUSD/yearProfit requirement 40Fixed Costs incl annuity 140 "Break Even incl. annuity 12 Ktons/year
Break Even Example
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20 April 2023 Profitability Assessment 11
MUSD/year
250 Revenue
200 Variable + Fixed Cost
150Fixed Cost incl. annuity
100
50
2.5 5.0 7.5 10.0 12.5 15.0Ktons/year
Break Even Analysis Graphics
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20 April 2023 Profitability Assessment 12
Economics of Scale
MUSD/year
250 RevenueLower fixed Cost but
200 higher Variable Cost (less automated)
150
100 Variable + Fixed Cost
50 Fixed Cost incl. annuity
2.5 5.0 7.5 10.0 12.5 15.0Ktons/year
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20 April 2023 Profitability Assessment 13
Massive and mighty!
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Financing
Equity (Shareholders Funds) Loans:
Regular Annuity Bullet
WACC
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Criteria / Measures
Return on Investment (/Equity) Pay Back Period Financial Statements NPV, IRR, B/C .... Multi Criteria Decision Making Risk Factor Efficient Frontier (Pareto)
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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)
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Operating Statement Revenue/Income - Costs => EBITDA - Depreciation, Inventory Movement,... - Interest of Loans => Profit before Tax (EBT) - Income Tax - Dividend =>Net Profit/Loss
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20 April 2023 Profitability Assessment 18
Cash Flow
Equity Drawdown Dividend
Taxes Interest &Repayment
Loans Drawdown
Sales Costs
Investment
Shareholders
Government Deb t Holders
Company Cash Account
Customers Suppliers
Fixed Assets
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Source&Application of Funds 1
Profit before Tax (from Op Statem) + Depreciation => Funds from Operations + Loans & Equity Drawdown => Funds for Allocation
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Source&Application of Funds 2
Allocation: Investment Repayment of Loans Paid Taxes Paid Dividend
=> Total Allocation of Funds
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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
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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 Movement20 April 2023 Profitability Assessment 22
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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 &
Capital20 April 2023 Profitability Assessment 23
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Financial Ratios
Debt Management (DR, DSC, LLCR) Liquidity (Current Ratios) Asset Management (Turnover
Ratios) Market Value (P/E, Internal Value) Profitability (ROI, ROE)
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20 April 2023 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
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20 April 2023 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?
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20 April 2023 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
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20 April 2023 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
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20 April 2023 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
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20 April 2023 Profitability Assessment 30
NPV Example:Interest
Project A: 10%Year Cash Flow Present Accum.
n An: Value: NPV0 -100 -100.0 -100.01 30 27.3 -72.72 30 24.8 -47.93 30 22.5 -25.44 30 20.5 -4.95 30 18.6 13.7
Sum: 50 13.7Internal Rate of Return 15.2%
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20 April 2023 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
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20 April 2023 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)
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20 April 2023 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%
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20 April 2023 Profitability Assessment 34
Relation of IRR to NPV
Interest Net PresentRate Value
0% 50.02% 41.44% 33.66% 26.48% 19.8
10% 13.712% 8.114% 3.016% -1.8 18% -6.2 20% -10.3
Net Present Value
-20.0
-10.0
0.0
10.0
20.0
30.0
40.0
50.0
60.0
0% 2% 4% 6% 8% 10%
12%
14%
16%
18%
20%
Interest Rate
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Comparison of investment alternatives Marginal Attractive Rate of Return
(MARR) Problems with uneven lifetimes Incremental Method
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20 April 2023 Profitability Assessment 36
To every problem there exists a solution!
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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
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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
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20 April 2023 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
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20 April 2023 Profitability Assessment 40
Example of Incremental Method
InterestProject B: 10%
YearCash Flow Present Accum.n An: Value: NPV0 -150 -150.0 -150.01 42 38.2 -111.82 42 34.7 -77.13 42 31.6 -45.64 42 28.7 -16.95 42 26.1 9.2
Sum: 60 9.2Internal Rate of Return 12.4%
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20 April 2023 Profitability Assessment 41
Difference B – A => IRR < MARR, so A is selected
Project B - A : 10%YearCash Flow Present Accum.
n An: Value: NPV0 -50 -50.0 -50.01 12 10.9 -39.12 12 9.9 -29.23 12 9.0 -20.24 12 8.2 -12.05 12 7.5 -4.5
Sum: 10 -4.5Internal Rate of Return 6.4%
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20 April 2023 Profitability Assessment 42
We can´t always be choosy!