Fixed Costs
Unit Break-Even Point =
Selling Price Per Unit Variable Cost Per Unit
$10,000
=
$10 $6
= 2,500 Units
Capital Budgeting
Strategic plans for
proposed large-dollar
investments
Examples:
New/replacement
equipment
New product line
Acquire firm or
division
C/B analysis using
models:
Payback period
Net present value
Profitability index
Internal rate of return
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 21
Evaluates the PV of all inflows and outflows of
a project using WACC as a discount rate
Net Present Value (NPV)
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 22
Where: C = net cash flow; i = discount rate; n = number of
periods; subscript indicates time period (1, 2, etc.); exponent
indicates compounding
If the only cash outflow is in the present:
NPV = PV of Cash Inflows PV of Cash Outflows
3 1 2 n
1 2 3 n
NPV = PV of Cash Inflows Cash Cost
C C C C
= + + +... + Cost
(1+i) (1+i) (1+i) (1+i)
A
1 2 3 4 5
B
1 2 3 4 5
$300 $300 $400 $100 $100
NPV = + + + + $1,000 = $ 48.43
(1 + .10) (1 + .10) (1 + .10) (1 + .10) (1 + .10)
$1,000 $1,000 $300 $300 $400
NPV = + + + + $1,00
(1 + .10) (1 + .10) (1 + .10) (1 + .10) (1 + .10)
0= $1,124.98
Net Present Value (NPV)
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 23
If WACC = 10%, two projects NPVs are:
Ratio of PV gained to cost to obtain that value;
value gained per dollar of investment:
If only cash outflow is in present (period 0):
Profitability Index (PI)
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 24
Present Value of Cash Inflows
Profitability Index =
Present Value of Cash Outflows
A
B
$951.57
PI = = 0.952
$1,000.00
$2,124.98
PI = = 2.125
$1,000.00
Discount rate (i) that makes NPV = 0
PV of cash inflows = PV of cash outflows
Internal Rate of Return (IRR)
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 25
=
A
1 2 3 4 5
B
1 2 3 4
NPV = PV of Cash Inflow Cost = 0
$300 $300 $400 $100 $100
NPV = + + + + $1,000 0 i = 7.7%
(1 + i) (1 + i) (1 + i) (1 + i) (1 + i)
$1,000 $1 $300 $300 $400
NPV = + + + +
(1 + i) (1 + i) (1 + i) (1 + i)
=
5
,000
$1,000 0 i = 38.1%
(1 + i)
Method
Acceptance
Criterion
Project A
Project B
NPV NPV > 0 $48.43 $1.124.98
PI PI > 1 0.952 2.2125
IRR IRR > WACC* 7.7% 38.1%
Capital Expenditure Analysis Summary
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 26
* WACC = 10% in the example
Risk analysis
Sensitivity analysis
How do changes in
single variable influence
NPV?
Scenario analysis
What-if analysis of best
and worst cases (NPV)
Monte Carlo simulation
RADR
High-risk endeavors:
higher rate of return to
justify investment
Risk adjustment factor,
e.g., 2% if WACC is
10%
Low-risk: 8%
Medium-risk: 10%
High-risk: 12%
Investment Risk Analysis and RADR
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 27
Risk-Adjusted Return
on Capital (RAROC)
Originally for FI
project evaluation
Uses risk estimate to
adjust return on
capital calculations
Comparable
Expected loss (EL)
Nonfinancial issues
Market ready?
Technology ready?
Regulatory mandate?
Other Cost/Benefit Analyses
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 28
Discussion Question
How do treasurys plan assessments affect
projected cash flow streams in budgeting?
a) Calculates adequate funds and liquidity
b) Determines impact on debt covenants and credit
ratings
c) Manages financing of long-term assets through
debt and equity issues
d) Treasury is not directly or indirectly
responsible for budgeting
Answer: b (p.5-58)
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 29
Budgets Pro Forma Financial Statements
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 30
Suppliers: Sales on credit?
Trading partners: Can counterparty meet
contractual obligations?
Lenders: Initiate/maintain credit relationships?
Rating agencies: Credit risks?
Investors: Purchase/sell corporate debt and
equity?
Financial Statement Analysis
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 31
Financial Statement Analysis Ratios
Liquidity or working
capital ratios
Efficiency or asset
management ratios
Debt management
ratios
Performance ratios
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 32
Discussion Question
How do common-size statements enable direct
financial comparisons of different size firms?
a) Expenses as % of profit reveal who has the best
expense controls
b) Asset categories as a % of revenues can be
compared
c) Liability categories as a % of total assets can
be compared
d) Cash flow elements as a % of net income
can be compared
Answer: c (p.5-63)
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 33
How many times asset base is used (turned
over) with flow of revenue.
Example: Firm generated $0.968 of revenue per
$1 of investment in assets.
Total Asset Turnover
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 34
Revenues
Total Asset Turnover =
Total Assets
$15,000
= = 0.968 Times
$15,500
How efficiently fixed assets, or property, plant
and equipment, are used.
Example: Firm generated $2 revenue for each
$1 invested in fixed assets.
Fixed Asset Turnover
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 35
Revenues
Fixed Asset Turnover =
Net Property, Plant, Equipment
$15,000
= = 2.0 Times
$7,500
How many times firm turned over stock of
most liquid assets with flow of revenue.
Example: Firm generated $1.88 of revenue per
$1 in current asset accounts.
Current Asset Turnover
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 36
Revenues
Current Asset Turnover =
Current Assets
$15,000
= = 1.88 Times
$8,500
Efficiency with which company converts sales
into cash.
Example: $0.037 of cash was carved out of
each revenue dollar.
Cash Conversion Efficiency
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 37
Cash Conversion
Cash Flow from Operations
Efficiency =
Revenues
$550
=
$15,000
= 0.037 or 3.7%
Discussion Question
Which three ratios help determine the extent to
which a company was leveraged?
a) Total liabilities to total assets
b) Times interest earned ratio
c) Long-term debt to capital
d) Debt to tangible net worth
e) Fixed charge coverage ratio
Answer: a, c, d. Degree of indebtedness
ratios: The higher the ratio, the greater the
relative indebtedness. (p.5-68)
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 38
Percentage of all liabilities to total investments
or total assets.
Example: Some form of debt supplies $0.471 of
each $1 of assets.
Total Liabilities to Total Assets
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 39
Total Liabilities
Total Liabilities to Total Assets =
Total Assets
$7,300
= = 0.471 or 47.1%
$15,500
What percentage of capitalization is provided
by long-term debt.
Example: Long-term (L/T) debt supplied 32.2%
of total capital.
Long-Term Debt to Capital
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 40
-
-
Long Term Debt
L/T Debt to Capital =
Long Term Debt +Equity
$3,900
= = 0.322 or 32.2%
$3,900 + $8,200
Debt as a percentage of tangible net worth.
Intangibles: goodwill, patents, trademarks, and
copyrights.
Example: Sum of short- and long-term interest-
bearing debt is 69.5% of tangible net worth.
Debt to Tangible Net Worth
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 41
Total Debt
Debt to Tangible Net Worth =
Total Equity Intangible Assets
$1,800 + $3,900
= = 0.695 or 69.5%
$8,200 $0
Ability to service debt via interest payments.
Example: Firm has 5.33 times more funds
available to pay interest than interest that was
paid.
Times Interest Earned (TIE) Ratio
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 42
Operating Profit EBIT
TIE = =
Interest Expense Interest Expense
$1,600
= = 5.33 Times
$300
Performance: Profit Margins
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 43
Percentage of
revenues remaining
after deductions:
Gross: COGS
Operating: COGS +
operating expenses
EBITDA: same as
operating
but add back
depreciation and
amortization
Net: all expenses
and taxes
Gross
Gross Profit
Profit Margin =
Revenues
Operating
EBIT
Profit Margin =
Revenues
EBITDA
EBITDA Margin =
Revenues
Net Profit
Net Income
Margin =
Revenues
Net income relative to level of total assets.
Example: Every $1 in total assets generates
$0.055 in net income.
Return on Total Assets (ROTA)
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 44
Net Income
Return on Total Assets =
Total Assets
$850
=
$15,500
= 0.055 or 5.5%
Earnings available to common shareholders
expressed as a percentage of common equity.
Example: Firm earned $0.104 of accounting net
profit for each $1 of common equity
investment.
Return on Common Equity
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 45
Return on Total Assets = Return on Sales Total Asset Turnover
Net Income Total Revenues
=
Total Revenues Total Assets
= 0.057 0.968 = 0.055 or 5.5%
Discussion Question
Why do service industry ratios differ from
manufacturing industry ratios?
a) Balance sheets have higher current assets,
especially A/R
b) Service firms have higher debt
c) Supply costs are always low
d) Asset turnover is more
important than profit margin
Answer: a (p.5-74)
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 47
Advantages:
Easily computed and
widely used
Information easily obtained
Easy comparison between
companies
Disadvantages:
Historical data at fixed points,
not intra-period
No future performance
promise
Not best in isolation
(comparative or trend)
Accounting information not
economic value
Not qualitative value
(strategies, talent)
Accounting methods may
reduce comparison validity
Strengths and Limitations of Ratio Analysis
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 48
Return on investment (ROI)
Partial period may be misleading.
Does not include cost of capital.
Positive NPV project rejected if it lowers firms ROI?
Performance Measurement
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 49
Net Income Net Income
ROI = =
Invested Capital Long-Term Debt + Equity
Residual income (RI)
Assigns charge to the invested capital.
If profit exceeds charge for capital, then RI is a
profit.
Free cash flow (FCF)
Performance Measurement
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 50
FCF = Net Income Depreciation and Amortization
Change in Non-Cash Working Capital Capital Expenditures
RI = Net Income Invested Capital Cost of Capital
Value created only if firm earns a rate of return
that exceeds its WACC
Example: EVA of a company with:
Long-term debt of $3,900, equity of $8,200
Marginal tax rate of $450/$1,300
WACC of 10%
Operating income (EBIT) of $1,600
Economic Value Added (EVA)
v4.0 2013 Association for Financial Professionals. All rights reserved. Session 10: Module 5, Chapter 19 - 51