Criteria and methods for evaluating investment projects, Estimation...

Criteria and methods for evaluating investment projects

As a result of studying the material in this chapter, the student must:

know

• Methods for evaluating the effectiveness of investment projects;

• the essence and measures of inflation;

• the main approaches to the formation of the capital budget;

be able to

• determine the relative effectiveness of investment projects with unequal time frames for implementation;

own

• The skills of accounting for inflation in investment analysis.

Estimation of the cash flows of the investment project

Investment project, like any financial operation, generates cash flows. Any benefits expected from an investment project are expressed in the form of incoming and outgoing cash flows, rather than in the form of profit flows accounted for in the balance sheet. Thus, in order to assess the effectiveness of the investment project, it is necessary to build the cash flow of the investment project and evaluate it.

When making investment decisions, like all other managerial decisions, one must proceed from the relevant information. Relevant costs and revenues change when making a decision, while making a decision does not affect irrelevant costs and revenues.

Consider the typical composition of cash flows associated with capital investments.

Incoming cash flows include:

- additional revenue;

- lower costs;

- liquidation value;

- the release of working capital.

Outgoing cash flows include:

- initial investment;

- increase in working capital;

- repair and maintenance;

- additional operating costs.

You can talk about the three categories of cash flows related to a particular project.

Initial cash expenditure (initial net investment ), which takes into account the costs of acquiring, installing and installing equipment, changes in net working capital, proceeds from the sale of the assets being replaced and related tax adjustments.

Intermediate incremental cash flow, ie. the cash flow generated by these investments, but not including the final cash flow.

The incremental net cash flow of the closing year, which includes:

• the release of working capital. The volume of investments includes investments in the current assets of the organization, the need for which is due to the creation of inventories and increase in accounts receivable. By the end of the project, these reserves are eliminated, leading to the emergence of additional positive cash flow in the last year of the project;

• the residual value of the equipment. If the life cycle of the project and the useful life of the equipment do not coincide, then at the end of the project the company has equipment that has a residual value. Consequently, in the last year there is a positive cash flow equal to the residual value of the equipment if it is intended to use it for the purposes of another project, or the projected cost of its sale in the event of an anticipated sale.

When evaluating the effectiveness of an investment project, a comparison is made between the initial volume of investment and the cash flow generated by these investments (and not with profit), so the resulting profit values ​​need to be recalculated for the amount of cash flow. There are two calculation schemes for this recalculation: the traditional scheme and the scheme of own capital.

When estimating cash flows, both depreciation is not included in the first and second cases, since it is a non-monetary item of expenditure. The outflow of money occurred at the time of the acquisition of depreciable assets, and it should be taken into account at the beginning of the project. Inclusion of depreciation charges will lead to a recurring account and will distort the cash flow estimate, underestimating the project's efficiency indicators.

Consider the procedure for constructing the cash flow of an investment project using the traditional scheme. This scheme is used when it is necessary to determine the return on all the invested capital (own and borrowed):

1) as the discount rate is the weighted average cost of capital ( WACC);

2) when forecasting cash flows, interest payments, loan collection, repayment of the main part of the credit investment, payment of dividends are not taken into account. This is due to the fact that according to the traditional scheme, the return on all the invested capital is determined, which includes the loan attracted for the project. The cost of the loan is taken into account when choosing the discount rate, therefore, the inclusion of interest payments to the cash flows will result in a re-account and underestimate the effectiveness of the project. The tax savings that arise from the fact that interest on a loan are expensed and reduce the taxable base is also taken into account when determining the discount rate;

3) The internal rate of return (IRR) is compared with the weighted average cost of capital, since the cash flow generated by the investment should recoup the cost of both its own and borrowed capital (calculation of the indicator IRR is considered in paragraph 4.2).

The methodology for constructing the cash flow of an investment project under the equity scheme is used in cases where it is required to determine the return on equity. This scheme assumes the following:

1) the cost of equity is the discount rate;

2) when forecasting cash flows, interest payments, obtaining a loan, repayment of a major part of a loan investment are accounted for;

3) the internal rate of return ( IRR ) is compared with the cost of equity, since the cash flow generated by the investment should recoup the cost of equity, which is accounted for as part of investment costs. The borrowed capital in the investment costs is not included.

Let's consider a technique of construction of a monetary stream of the investment project on a concrete example.

Example

Investment needs amount to 15 000 thousand rubles, of which fixed assets - 13 300 thousand rubles, working capital - 1700 thousand rubles.

The useful life of the equipment is 7 years. Depreciation is accrued on a straight-line basis.

Sources of financing of these investments include own funds in the amount of 6,000 thousand rubles. and borrowed funds in the amount of 9,000 thousand rubles. (cost of 14%). The debt is repaid by equal annual payments.

Project duration is 5 years.

The parameters of the company's operating activities are as follows: sales volume - 100 thousand items per year; the price of the products is 600 rubles. for a unit; variable costs - 420 rubles. per unit of output; fixed costs (without depreciation) - 9000 thousand rubles. per year.

Let's construct cash flows of the project according to the traditional scheme and according to the scheme of own capital.

1. The construction of cash flows according to the traditional scheme.

The annual revenue will be (100 000 • 600) = 60 000 thousand rubles. The annual variable costs will be (100 000 • 420) = 42 000 thousand rubles. The annual amount of depreciation is (13 300/7) = 1900 thousand rubles. The residual value of the equipment will be (13 300 - 5 • 1900) = 3800 thousand rubles. (Table 4.1).

Table 4.1

Metric, thousand rubles

Year

0th

1st

2nd

3rd

4th

5th

Investments

-15 000

Revenue

60 000

60 000

60 000

60 000

60 000

- Variable costs

42 000

42 000

42 000

42 000

42 000

- Constant costs (without depreciation)

-

9000

9000

9000

9000

9000

- Depreciation

1900

1900

1900

1900

1900

= Operating profit (EBIT)

-

7100

7100

7100

7100

7100

- Income tax (20%)

-

1420

1420

1420

1420

1420

= After-tax operating profit

-

5680

5680

5680

5680

5680

+ Depreciation

1900

1900

1900

1900

1900

+ Residual equipment cost

-

-

-

-

-

3800

+ Release of working capital

-

-

-

-

-

1700

= Cash Flow

-15 000

7580

7580

7580

7580

13,080

Note that when determining the profit tax, tax saving, arising from the use of borrowed capital, was not taken into account. This tax saving when assessing the effectiveness of an investment project under a traditional scheme is taken into account when determining the discount rate (when calculating the cost of borrowed capital). The cash flow, built according to the traditional scheme, is generated by cumulative investments, which include both investments of own and borrowed capital. Therefore, this cash flow must ensure the required return on all invested capital.

2. The construction of cash flows according to the scheme of own capital.

When constructing cash flows under the scheme of equity capital, the interest on the loan and repayment of the principal amount of the debt should be included in the cash flows. Therefore, it is necessary to build a repayment schedule, dividing payments on the loan into two components: debt repayment and interest. Interest is charged to expenses, reducing the taxable base for income tax. Debt is repaid by equal annual payments, i.е. we are dealing with an urgent annuity (term of 5 years). The present value of the annuity is 9,000 thousand rubles. (loan amount).

Calculate the annual fee:

therefore, thousand rubles. The repayment schedule is shown in Table. 4.2.

Table 4.2

Metric, thousand rubles

Year

1st

2nd

3rd

4th

5th

Initial debt balance

9000

7638.3

6086.0

4316.3

2298.9

Annual Payment

2621.7

2621.7

2621.7

2621.7

2621.7

Repayment of debt

1361.7

1552.3

1769.7

2017.4

2298.9

Interest

1260

1069.4

852.0

604.3

321.8

Final debt balance

7638.3

6086.0

4316.3

2298.9

0

The construction of cash flows of the investment project under the scheme of own capital is presented in Table. 4.3.

Table 4.3

Metric, thousand rubles

Years

0th

1st

2nd

3rd

4th

5th

Investments

-15 000

-

-

Getting a loan

9000

-

Revenue

60 000

60 000

60 000

60 000

60 000

- Variable costs

-

42 000

42 000

42 000

42 000

42 000

- Constant costs (without depreciation)

-

9000

9000

9000

9000

9000

- Depreciation

1900

1900

1900

1 900

1900

= Operating profit (EBIT)

-

7100

7100

7100

7 100

7100

- Interest payments

1260

1069.4

852.0

604.3

321.8

= Profit before taxation

-

5840

6030.6

6,248

6495.7

6778.2

- Income tax (20%)

1168

1206.1

1249.6

1299.1

1355.6

= Net Income

4672

4824.5

4998.4

5196.6

5422.6

+ Depreciation

1900

1900

1900

1900

1900

- Repayment of debt

1361.7

1552.3

1769.7

2017.4

2298.9

+ Residual equipment cost

3800

+ Release of working capital

-

-

-

-

-

1700

= Cash Flow

-6000

5210.3

5172.2

5128.7

5079.2

10 523.7

When constructing cash flows according to the scheme of own capital, the cash flow generated by investments of own capital is shown, and, therefore, it must provide the required return on equity.

Also We Can Offer!

Other services that we offer

If you don’t see the necessary subject, paper type, or topic in our list of available services and examples, don’t worry! We have a number of other academic disciplines to suit the needs of anyone who visits this website looking for help.

How to ...

We made your life easier with putting together a big number of articles and guidelines on how to plan and write different types of assignments (Essay, Research Paper, Dissertation etc)