Calculating returns

 Absolute return r = C1 + c2+.... + Cn C0  Relative return r = C1 + c2+.... + Cn C0 C0  Annual return r = C1 + c2+.... + Cn C0 * 365 C0 t
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Evaluating investments - and funding them

 What is a good investment ?  Which investment alternative is better ?  Where can we raise the funds to make a necessary
investment ?  How much should we pay for those funds ?

 We need a method which allows us to evaluate these

things and put a value on them. The best method in most cases is discounting cash flows, which gives us a Net Present Value (NPV)
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Using cash flows

 A financing or investment decision can have a large

number of different consequences: efficiency, quality, profit, cash position, personnel etc  But you cannot compare apples and pears so we must have a common value, money  But money can be looked at in many ways: pretax profit, net profit, cash flow, share value etc  The solution is to look only at what is 100 % objective and verifiable cash flow  So all aspects are evaluated based on their effect on the company cash flow
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Discounting cash flows

 A euro today is worth more than a euro tomorrow  A guaranteed euro is worth more than a risky euro  The method of adjusting a cash flow for risk and the time
effect is called discounting  Here all future cash flows are converted into cash equivalents, into todays safe money  Alternatively, convert all values to a common future date value !
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NPV example

 PV = C/(1+r)t for a single-period cash flow  PV = C1/(1+r)1 + C2/(1+r)2 + + Cn/(1+r)n for a multiple-

period cash flow  NPV is a net of positive and negative cash flows  C is the cash flow, r is the opportunity cost of capital, what an equally risky investment would pay on the capital markets

 Example: what is the NPV of paying out 100 today and

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receiving 60 after one year and 60 after another ? r = 10 %

NPV example

 Example: what is the NPV of paying out 100 today and

receiving 60 after one year and 60 after another ? r = 10 %

 NPV = -100/(1+0,10)0 + 60/(1+0,10)1 + 60/(1+0,10)2  NPV = -100 + 54,54 + 49,59 = 4,13

Difficulties with NPV

etc ?  Deciding the appropriate discount rate r  calculate the company cost of capital (current)  using market values from the capital markets  but we have to adjust for the risk of this particular project, which is unique
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 Identifying the cash flows  how large ?  when ?  what about less tangible effects e.g. quality of products

Other possible methods

 Payback time how long does it take to get the money back
 does not consider risk  does not consider the time effect of money

 Return on book value

 does not consider the time effect  is based on accounting values, which are affected by accounting and tax
issues, not objective cash flows

 Internal Rate of Return IRR the discount rate which gives NPV = 0
 does not consider the monetary gain, a higher IRR can mean less money if
the investment is smaller  in some cases there can be multiple IRR:s

 So NPV is the best method, regardless of what the companies are used
to !
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Risk and return

 Determining the correct opportunity cost is difficult

 for a risk-free investment it is the market interest on risk-free debt
(e.g. a government bond)  for an investment which does not alter the companys risk we can use the companys current cost of capital, which we can calculate  there are various theories and methods that help us quantify risk, some are covered later, but they are hard to use in practice  many companies use some rules-of-thumb e.g.

 low risk market risk-free rate + 3 %  medium risk risk-free rate + 8 %  high risk risk-free rate + 18 %
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Identifying the cash flows

 All aspects need to be converted to a cash flow

 investment paid out  increased revenues +  cost savings +  sale of asset +  etc  Normally enough to assume cash flows occur once a year (at the end)  Starting point is end of year 0. First cash flow after that is end of year 1  Multiple cash flows in a year can be summed to give one net only to discount
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Example 1

 The company is planning an investment into new software,

the cost of which is 10.000  An annual license fee of 500 is also payable  The sales department expects the software to give annual savings year 1 of 1000 , years 2-5 2000 . After five years the software is replaced  User training in the first year amounts to 3000  Because of the software, sales are expected to increase 2000 in years 2-5. Gross margin is 50 % (e.g. our profit on the sales)  Identify the cash flows !  Calculate NPV using 8 % discount rate
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Example 2

 A machine is purchased for 10.000  The annual depreciation is 2.000 /year  After three years use, it is upgraded for 5.000  After 8 years it is sold for 3.000  Annual cost savings are 3.000  Opportunity cost is 11 %  What is the NPV ?
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Some special cash flows

 Perpetuity  a cash flow which goes on forever  either a constant sum  or a sum, which increases by some percentage every
year  Annuity  a constant cash flow that goes on for a specified number of years  e.g. a mortgage (loan to buy a house)
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Perpetuities

 PV = C/r  a constant sum C received every year forever  r is the discount rate  PV = C/(r-g)  C is the cash flow in year 1, grows by g % every year

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Example

 An investment of 1000 into a share which is expected to

pay out a dividend of 100 per year forever  Opportunity cost is 12 %  Is it a good investment ?

 If the dividend (100 in year 1) is adjusted for inflation and

therefore increases by 3 % per year, is it a good investment ?

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Annuities

 An annuity is part of a perpetuity  First, calculate the perpetuity from the start  From that, deduct the PV of the perpetuity, which is not
included, e.g. from the end of the annuity

 PV = C * [ (1/r) (1/(r*(1+r)t)) ]
where the sum of C is paid from year 1 to t
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Example

 You have been offered to rent a flat for 10 years. You can
choose between paying 10.000 immediately and pay no rent or pay an annual rent of 1.500 at the end of every year.  You can get a loan of 10.000 from the bank at a fixed interest of 6 %  Which alternative is better for you ?

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Inflation

 Inflation is the annual overall increase of prices in the

community  Currently low in Europe (2-3 %), but has historically been much higher (10 + %)  In developing countries or some sort of crisis it can be very high (100 + %)  Interest rates are usually given as nominal rates.  Adjusting a nominal to a real rate is using the formula 1+rreal = (1+rnominal)/(1+inflation)  When discounting, be consistent: nominal cash flows using nominal rates or real cash flows using real rates. Never mix the two !
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Compound and simple interest

 Simple interest assumes that interest received is not

reinvested  Compound interest assumes that interest received is reinvested at the same rate, so you earn interest on interest  In finance, compound interest is normally assumed  Discounting is based on compound interest

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