2. Corporate Finance
3. The first golden rule: Time
4. Payback period
5. The second golden rule: Risk
6. The most common mistake of Financial and non-Financial managers
7. Net Present Value
8. Internal Rate of Return
9. WACC Average cost of capital
Based on which criteria do you rate an investment? How do you compare totally different projects? What is important for the Finance Director? In this article you read the most important assessment principles and how they are incorporated in the three most commonly used investment metrics!
1. Prior knowledge: The three overviews of Financial Management, the Balance Sheet, the Profit and Loss Statement and the Cash Flow Statement
Financial Management aims to reflect the situation of the company by means of numbers. Financials use three overviews to provide this insight:
- The Balance sheet that is a snapshot of all the assets of the company on the left (Asset) side and on the right side (Equity & Liabilities) the ownership distribution.
- The Profit and Loss Statement which shows the value of the activities performed (turnover) and that what is used (costs) for the performed activity in the period. Management Accounting is the discipline that is based on the Profit and Loss Statement and therefore relates to realized minus consumed, for example, cost prices, quantity and price differences, cost allocations and so on.
- And third overview is the Cash Flow Statement, which is a periodical overview of all cash flows in and out of the company. Corporate Finance is the discipline that works from the cash flow statement and relates to major capital decisions.
If you have difficulty understanding the article below, first read the articles concerning the three financial statements. This will contribute vastly to your financial insight.
The Corporate Finance discipline focuses on assessing possible investments. This is done on the basis of cash in versus cash out. Note: If you work on an investment proposal, make sure that you do not mix using something (costs) with paying for something (cash out). Likewise do not mix up delivering (revenue) with receiving (cash in). Your customers have a payment term or in a bad situation might not e able or willing to pay you.
It is deadly for your proposal if you confuse these concepts because it shows your lack of knowledge of financial management and will completely discredit your proposal, no matter how good the project might be.
Read my article on the eight most common mistakes of managers if you are not 100% sure of the difference.
When assessing the worth of an investment it is very important to know that you want the money back as soon as possible. Time is a very important criteria in assessing investments. There are two reasons for this. First of all if I receive the money back soon it enables me to invest in another project which will bring me a yield. Secondly time is important because it makes you venerable, having cash enables you to react to changing circumstances, in other words you do not want to ty up your capital. Because the timing of the cash inflow and outflow is of great importance we use the cash flow statement as a basis for all investment metrics.
Time as a financial indicator
How do we translate time into a financial indicator? Put simply: for every year that the money is stuck, I want something in return. We call this the interest (or Profitability) and is a percentage of the amount of money invested.
With a time period of 1 year at 10% interest the following occurs. Start investment € 1,000 in a company.
- If I get my money back after 1 year, I expect € 1,000 + 10% = 1,100
- If I get my money back after 2 years I expect (€ 1,000 + 10%) + 10% = 1,210
- If I get my money back after 3 years I expect ((€ 1,000 + 10%) + 10%) + 10%) = 1,331
Or calculating backwards: If I get € 1000 in 8 years’ time that is now worth € 467.
The most important criterion for time is the Pay-back period. With this standard I determine how long it takes before I have the money that I put into project back in my pocket. This standard is therefore expressed in years and months.
An example: Suppose I have a project where I have the following cash flows:
I start with an investment of 1000 and after 1 year I receive 200. At the end of the first year I still have a negative cash flow of -800. In the second year I receive 400. At the end of the second year I still have a cash flow of -400. In the third year I receive 800. Halfway through the third year I will reach zero. The Pay-back period for the investment is 2.5 years.
A disadvantage of the payback time as a yardstick for evaluation is that it does not take into account the cash flows after the original investment has been earned back. Within too many companies, this criterion is not applied based on this disadvantage. The biggest advantage is the simplicity and it indicates when I can react again, a very important feature and the reason that every investment should also be judged according to this criterion.
Additionally to the question how long does it take before I receive my money back, you should ask yourself: And how certain am I that the money comes back? Or in other words how big is the risk of failure? Is it all or nothing or can there be any conceivable in between results? And could we take measures to ensure that risks are reduced or mitigated?
Risk as a financial indicator
Financial people use the Greek letter ß (Beta) as an indicator of the risk. Where "no risk" is shown as ß=0 and average market risk as ß=1. A risk of ß=0.5 means that this project has half as much risk as the average of all projects (the market risk). If you have a risk of 2, then it is an extremely risky project. New companies, the so-called start-ups, are traditionally very risky because they still have to prove their right to exist both in terms of product, market and organization. A risk of less than zero can also occur if a project responds in the opposite way to the development in the market. For example, you can think of the gold price. If the economy is going down, many people flee into gold and therefore the price of gold goes up if the stock market goes down.
How do financials incorporate risk into the calculations? Start investment € 1,000 in a company.
- If I receive my money after 1 year with low risk, I am happy with € 1,000 + 5% = 1,050
- If I get my money back after 1 year with normal risk, I expect € 1,000 + 10% = 1,100
- If I get my money back after 1 year with high risk, I want at least € 1,000 + 15% = 1,150
Because the return is expected year on year, this has a major impact on long-term cash expectations. Suppose I have two projects. Project “Low risk” delivers 1500 after 8 years and project “High risk” delivers 3000 after 8 years. Based on the assumed risk of the projects it is therefore better to invest in “Low”.
Or calculating backwards if I get € 1000 in 8 years, that is now € ... worth.
The risk of the project determines the expected revenue. The interest percentage against which you can borrow is irrelevant! Because the latter is based on the capital structure of the entire company, and not on the risk of the project.
An example to explain this: Imagine you have two projects as a company. The first Project H is a high risk project. The expected revenues are very high but also uncertain. In addition, there is Project L, where yields are low but the risks are very small. You can get enough money from the bank to do one of the two projects.
Everyone knows that you want to invest only in H if the yields are much better compared to L. If not you would invest in L even though the expected profits are less. The interest percentage against which you can borrow as a company is therefore not important in this consideration! The revenue-to-risk ratio is decisive. Also check out my article 'The eight most common mistakes'.
But how do Financials compare two completely different projects? How do they choose between risky or low risk projects? With the Net Present Value and the Internal Rate of Return. And the best thing about Finance is that it makes no distinction, every earned euro is equally beautiful!
The start of the Net Present Value calculation is always an assessment of all expected cash flows per period.
To determine the value of the project we have to bring all values back to one and the same time, for the NPV to the beginning. But how do we do that? The 200 that we get after one year what is it worth now? That depends on the risk! Suppose we work with a risk profile of 10%.
Then the current value of the 200 that I receive in T1 200 / (1 + 10%) = 200 / 1.1 = 181
I can calculate the 400 that I receive after two years in a similar fashion to the present value. First of all I have to bring the 400 back from T2 to T1, I do this by dividing the 400 / (1 + 10%). Then additionally I have to bring the value back from T1 to T0. I do this by dividing the result of the previous again by 1 + 10%.
The current value of the 400 I receive in T2 400 / (1 + 10%) / (1 + 10%) = 200 / 1.1 / 1.1 = 301
The cash flows I receive over the years are all brought back to the moment of the initial investment.
|Current Value CF||-1000||181||301||601||546|
|Sum of Current Value CF||630|
We also refer to this net sum of the current cash flows as the Net Present Value!
Returning to the above projects H and L. Project H will be discounted by 15% over time, while project L will be discounted by 5%. The project that yields the most, taking into account the time and risk, is chosen.
The Net Present Value is the most frequently used investment criterion. All cash flows are assessed and both time and risk are included in the valuation. The outcome of the Net Present Value is an amount in euros. This is the overflow of return generated by the project on top of the required time and risk factor. Of course it is very difficult to correctly estimate future cash flows, to challenge that, question the assumptions made. Secondly it is difficult to determine the exact risk of a project. That is why you can also work with the Internal Rate of Return.
The Internal Rate of Return calculates at which interest rate (which risk) the proceeds of the investment are equal to the investment. Or in other words how much risk can the project bear on the basis of the cash flows and still remain attractive. For the mathematicians among us it is one comparison with one unknown.
The same cash flows from the above example once again. The question is: at which rate is the 1000 of the investment equal to the cash flows of T1 = 200 plus T2 = 400 plus T3 = 800 plus T4 = 800
1000 = 200 / (1 + IRR) + 400 / (1 + IRR) ^ 2 + 800 / (1 + IRR) ^ 3 + 800 / (1 + IRR) ^ 4 => IRR = 31.63%
But what does this 31,63% mean? With a risk assessment of 31.63% the investment is at break even. So now I have to make an estimation whether the risk is higher or lower than 31.63%. This assessment is easier to make than the exact risk that I need at the NPV. The disadvantage of the IRR is that the outcome is a percentage that is more difficult to compare between projects. After all how much it should bring based on the risk, and therefore if it over or under performs is not included.
The WACC is the compensation the capital providers wish to receive from the company on the basis of the risk profile. Or in other words, how much do people who invest in this company expect to return from the company every year for the risks they take.
You can calculate this by:
- (Costs Equity *% Equity) + (Costs Debt *% Debt * 1-Tax%)
Or in other words
- (Dividend + (Interest * 1-Tax)) / Total Assets
In this formula it is important to remember that you may deduct the interest as costs before determining how much tax you have to pay. This in contrast to Dividend that is paid from Net Profit.
Can I use the WACC for the assessment of a new potential investment? NO!!!
Except if accidentally the average risk of the company equals the specific risk of the project. Always remember the basics. The risk of the project determines the required return from the project. If you do not do this, you will always opt for risky projects and as a consequence jeopardize the company's future in the long term! How you finance the project depends on the business situation of the company (For example, if you have a building on which you can take out a mortgage). Also read my article: The eight most common mistakes by managers.
The major highlights to remember from this article on investments:
- Make use of cash flows and not costs or depreciation.
- Time and risk are decisive criteria
- Challenge the assumptions made for the expected Cash Flow and risk.
- The Risk determines the expected return, not the cost of raising capital!
View all criteria, Payback period, Net Present Value and Internal Rate of Return. They each give their own specific insight into the investment. And just like with all financial assessments, more knowledge = more insight = better choices.
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