Financial Training
F2: Basic Financial Concepts
Diego Perez Lopez
Yangon – September 2019
Implemented by
Contents
• Time Value of Money: Static vs Dynamic Indicators
• Net Present Value
• Internal Rate of Return
• The profit and loss statement
• Cash flows
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Commonly used financial indicators
Profitability of an investment:
• Payback Period
• Net Present Value
• Internal Rate of Return
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Profitability of an investment: static vs dynamic indicators
Static investment calculation Dynamic investment calculation
• Profit-cost comparison • Net Present Value
• Payback period • Internal Rate of Return
No time value of money Time value of money
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Static indicators: profit vs cost and Payback period
Imagine we have the following cash flows in a project:
Year 0: -100 Cost vs profit:
Positive cash flows: + 170
Year 1: +20 Negative cash flows: -100
Total profit: +70
Year 2: +50
Year 3: 0 Payback period:
When does the initial investment get recovered?
Year 4: +70 Answer: in year 4
Year 5: +30
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Static indicators: profit vs cost and Payback period
Imagine we have the following cash flows in a project:
80
Year 0: -100
60
Year 1: +20 40
Year 2: +50 20
0
Year 3: 0
-20
Year 4: +70 -40
Year 5: +30 -60
-80
-100
-120
Annual CF Cumulative CF
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Dynamic indicators: time value of money
The “time value of money” concept is a key driver in dynamic investment calculation.
A cash flow occurring now has not the same value than a cash flow of the same amount in
two years’ time.
Try to answer the following questions to understand the challenge:
• What do you prefer: 100 USD today or 100 USD in one year?
• What do you prefer: 100 USD today or 110 USD in one year?
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Example of Present Value calculation
What is the value today of receiving 110 USD in one year?
We have to apply some “discount rate” called r… let’s say 10% per year
CF 110
V= = = 100 USD
(1 + r) (1 + 0,1)
And what if we have to wait for two years to receive the same 110 USD?
CF 110 110
V= = = = 90,9 USD
(1 + r)2 (1 + 0,1) 2 1,21
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Net Present Value
The net present value is the present value of future cash flows discounted at a certain hurdle or
discount rate
• The cash flows usually start with a negative cash flow, i.e. an investment, which then triggers
positive cash flows in the following years
• In order to calculate the NPV, the discount rate needs to be determined
• Rule: Only accept investments that have a positive NPV
• Rule: If you compare two investment opportunities, choose the one with the higher
NPV
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Net Present Value (NPV) exercise
• Calculate the NPV (discount rate 8%) for both opportunities below:
Project A: Project B:
Year 0: -100 Year 0: -100
Year 1: +20 Year 1: +70
Year 2: +50 Year 2: +50
Year 3: 0 Year 3: 0
Year 4: +70 Year 4: +20
Year 5: +30 Year 5: +30
• Before any calculation, which Project should have a higher NPV?
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Net Present Value (NPV) : which discount rate to use?
• If you have the funds: the discount rate should be the expected profitability of alternative
investment options.
• If you don’t have the funds: the discount rate should be the average cost of financing that
you will need to pay.
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Net Present Value formula
C1 C2 Ct
NPV = - Co + + +…+
(1 + r) (1 + r)2 (1 + r)t
• Ct: Cashflow in year t
• Co: Cashflow in year 0 (Initial investment)
• r: discount rate
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Internal Rate of Return (IRR)
The IRR is the discount rate, which, when applied to a stream of cash flows, generates a NPV of
zero
• The IRR can be compared to a hurdle rate or discount rate and at least to come in at a similar
level as the current WACC
• Rule: Accept investments that offer rates of return in excess of the benchmark or
hurdle rate!
• Rule: If you compare two investment opportunities, choose the one with the higher
IRR!
• A note of caution: The IRR calculation only considers the capital tied up in the project. For the
capital that is not tied up, it is assumed that it is paying the same return as the capital tied up
in the project.
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Internal Rate of Return (IRR) formula
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Internal Rate of Return (IRR) example
Source: Corporate Finance Institute
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Internal Rate of Return (IRR) exercise
• Calculate the IRR for both opportunities below:
Project A: Project B:
Year 0: -100 Year 0: -100
Year 1: +20 Year 1: +70
Year 2: +50 Year 2: +50
Year 3: 0 Year 3: 0
Year 4: +70 Year 4: +20
Year 5: +30 Year 5: +30
• Formula for Excel calculation: =IRR(year1:yearN)
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Relationship between NPV and IRR
Page 17 Financial Training – F2
Exercise 1
A company is considering renewing its productive equipment, which would require an investment of
10,000 euros. The company can choose between the A or B equipment, each of which will reduce
production costs during the five years of its useful life. The expected cost reduction over time is
provided in the table:
Net annual cost reduction
Equipment Year 1 Year 2 Year 3 Year 4 Year 5
A 500 800 2.400 3.000 5.400
B 50 1.000 2.500 2.900 6.500
With the above data, select the most convenient equipment for the company applying the Net Present
Value (NPV) criteria using a discount rate of 5%. Justify the answer.
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The Profit and Loss Statement (or income statement)
The P&L statement displays revenues, expenses and profit of a company over a given
period of time
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The Profit and Loss Statement: structure
Start with Sales and other revenues
Subtract Cost of goods sold
Equals Gross profit
Subtract Operating expenses (personnel, electricity, others…)
Equals EBITDA
Subtract Depreciation and amortization
Equals EBIT / Operating Profit
Subtract Interest expense
Equals Earnings Before Tax (EBT)
Subtract Income Tax
Equals Earnings After Tax (EAT)
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The Profit and Loss Statement: example from Amazon
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Cash flows: definition
A cash flow describes a payment (movement of money) in or out of a business, project
or financial product.
Types of cash flows in a company:
• Operating cash flow
• Investing cash flow
• Financing cash flow
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Project cash flows: how to calculate them
ZZ
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Project cash flows: initial outlay
Start with Capital expenditure
Subtract Increase in working capital
Equals Initial outlay
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Project cash flows: after tax operating cash flow
Start with Sales and other revenues
Subtract COGS and Operating Expenses
Subtract Depreciation
Equals Earnings before tax
Subtract Taxes
Equals Earnings after tax
Add Depreciation
Equals After-tax operating cash flow
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Project cash flows: terminal year cash flow
Start with After tax salvage value
Subtract Return of net working capital
Equals Terminal cash flow
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Comparison between Cash Flow and Profit & Loss statements
Cash flow Profit and Loss
Initial investment Yes No
Revenues Yes Yes
Costs Yes Yes
Depreciation No Yes
Interests Yes Yes
Taxes Yes Yes
Page 27 Financial Training – F2
Exercise 3
Suppose a company has the opportunity to bring out a new product, the Vitamin-Burger. The
initial cost of the assets is $100 million (to be depreciated linearly over their useful life), and
the company’s working capital would increase by $10 million during the life of the new
product.
The new product is estimated to have a useful life of four years, at which time the assets
would be sold for $5 million.
Management expects company sales to increase by $120 million the first year, $160 million
the second year, $140 million the third year, and then trailing to $50 million by the fourth year
because competitors have fully launched competitive products.
Operating expenses are expected to be 70% of sales, if the required rate of return on the
Vitamin-Burger project is 8% and the company’s tax rate is 35%, should the company invest
in this new product? Why or why not?
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As a federally owned enterprise, GIZ supports the German Author:
Government in achieving its objectives in the field of international
cooperation for sustainable development. Diego Perez Lopez
Deutsche Gesellschaft für Trama TecnoAmbiental
Internationale Zusammenarbeit (GIZ) GmbH
Registered offices
Bonn and Eschborn
“Promotion of Rural Electrification in Myanmar”
Rangoun Business Centre
97/A, 3rd Floor, West Shwe Gon Daing Road
Bahan Township, Yangon, Myanmar In cooperation with:
E [email protected] Implemented by
I www.giz.de
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