Analysis of Financial Statements_15

Analysis of Financial Statements

Financial management is largely concerned with financing, dividend and investment decisions of the firm with some overall goal in mind. Corporate finance theory has developed around a goal of maximizing the market value of the firm to its shareholders. This is also known as shareholder wealth maximization. Although various objectives or goals are possible in the field of finance, the most widely accepted objective for the firm is to maximize the value of the firm to its owners.

Financing decisions deal with the firm's optimal capital structure in terms of debt and equity. Dividend decisions relate to the form in which returns generated by the firm are passed on to equity-holders. Investment decisions deal with the way funds raised in financial markets are employed in productive activities to achieve the firm's overall goal; in other words, how much should be invested and what assets should be invested in. Throughout this book it is assumed that the objective of the investment or capital budgeting decision is to maximize the market value of the firm to its shareholders.

Funds are invested in both short-term and long-term assets. Capital budgeting is primarily concerned with sizable investments in long-term assets. These assets may be tangible items such as property, plant or equipment or intangible ones such as new technology, patents or trademarks. Investments in processes such as research, design, development and testing - through which new technology and new products are created - may also be viewed as investments in intangible assets.

Irrespective of whether the investments are in tangible or intangible assets, a capital investment project can be distinguished from recurrent expenditures by two features. One is that such projects are significantly large. The other is that they are generally long-lived projects with their benefits or cash flows spreading over many years.

Sizable, long-term investments in tangible or intangible assets have long-term consequences. An investment today will determine the firm's strategic position many years hence. These investments also have a considerable impact on the organization's future cash flows and the risk associated with those cash flows.

Evaluation Criteria

n 1. Discounted Cash Flow (DCF) Criteria

n Net Present Value (NPV)

n Internal Rate of Return (IRR)

n Profitability Index (PI)

n 2. Non-discounted Cash Flow Criteria

n Payback Period (PB)

n Discounted Payback Period (DPB)

n Accounting Rate of Return (ARR)

. DISCOUNTED CASH FLOW (DCF) CRITERIA

NET PRESENT VALUE (NPV)

The net present value (NPV) method is the classic economic method of evaluating the investment proposals. It is one of the discounted cash flow (DCF) techniques explicitly recognizing the time value of money. It correctly postulates that cash flow arising at different time periods differ in value and are comparable only when their equivalents-present values-are found out. The following steps are involved in the calculation of NPV:

v Cash flows of the investment project should be forecasted based on realistic assumptions.

v Appropriate discount rate should be identified to discount the forecasted cash flows. The appropriate discount rate is the firm’s opportunity cost of capital which is equal to the required rate of return expected by investors on investments of equivalent risk.

v Present value of cash flows should be calculated using opportunity cost of capital as the discount rate.

v Net present value should be found out by subtracting present value of cash outflows from present value of cash inflows. The project should be accepted if NPV is positive(i.e. NPV>0)

ILLUSTRATION

Assume the Project X costs Rs.2500 now and is expected to generate year end cash inflows of Rs.900, Rs.800, Rs.600 and Rs.500 in years 1 through 5.The opportunity cost of the capital may be assumed to be 10 per cent.

The net present value for Project X can be calculated by referring to present value table. The calculations are shown below:

NPV= Rs.900 + Rs.800 + Rs.700 + Rs.600 + Rs.500 - Rs.2500

(1+.10) (1+.10)² (1+.10)³ (1+.10)⁴ (1+.10)⁵

NPV=[Rs.900(PVF₁,.10)+Rs.800(PVF₂,.10)+Rs.700(PVF₃,.10)+Rs.600(PVF₄,.10)+Rs.500(PVF₅,.10)]

NPV=[Rs.900x0.909+Rs.800x0.826+Rs.700x0.751+Rs.600x0.683+Rs.500x0.620]- Rs.2500

NPV= Rs.2725 – Rs.2500 = + Rs.225

Project X’s present value of cash inflows (Rs.2725) is greater than that of cash outflow (Rs.2500) Thus, it generates a net present value (NPV = + Rs.225).Project X also adds to the wealth of owners; therefore, it should be accepted.

The equation for the net present value can be written as follows :

NPV = C₁ + C₂ + C₃ + …. + C_n - C₀

1+k) (1+k) ² (1+k) ³ (1+k) ⁿ

where C₁,C₂ …. represent the net cash inflows in year 1,2…., k is the opportunity cost of capital, C₀ is the initial cost of the investment and n is the expected life of the investment. It should be noted that the cost of capital, k, is assumed to be known and is constant.

Why NPV is important?

A question may be raised: why a financial manager should invest Rs.2500 in Project X? Project X should be undertaken if it is best for the company’s shareholders; they would like their shares to be as valuable as possible. Let us assume that the total market value of a hypothetical company is Rs.10000, which includes Rs.2500 cash that can be invested in Project X. Thus, the value of the company’s other assets must be Rs.7500. The company has to decide whether it should spend cash and accept Project X or keep the cash and reject Project X. Clearly Project X is desirable since its PV (Rs.2725) is greater than the Rs.2500 cash. If Project X is accepted the total market value of the firm will be: Rs.7500 + PV of Project X=Rs.7500 + Rs.10225; that is, an increase by Rs.225. The company’s total market value would remain only Rs.10000 if Project X is rejected.

Why should the PV of Project X reflect in the company’s market value? To answer this question, let us assume that a new company X with Project X as the only asset is formed. What is the value of the company? The market value of a company’s shares is equal to the present value of the expected dividends. Since Project X is the only asset of Company X, the expected dividends would be equal to the forecasted cash flows from Project X. Investors would discount the forecasted dividends at a rate of return expected on securities equivalent in risk to company X. The rate used by investors to discount dividends is exactly the rate which we use to discount cash flows of Project X. The calculation of the PV of Project X is a replication of the process which shareholders will be following in valuing the shares of company X. Once we find out the value of Project X, as a separate venture, we can add it to the value of other assets to find out the portfolio value.

The difficult part in the calculation of the PV of an investment is the precise measurement of the discount rate. Funds available with a company can either be invested in projects or given to shareholders. Shareholders can invest funds distributed to them in financial assets. Therefore, the discount rate is the opportunity cost of investing in projects rather than in capital markets. Obviously, the opportunity cost concept makes sense when financial assets are of equivalent risk as compared to the project.

An alternate interpretation of the positive net present value of an investment is that it represents the maximum amount a firm would be ready to pay for purchasing the opportunity of making investment, or the amount at which the firm would be willing to sell the right to invest without being financially worse-off. The net present value (Rs.225) can also be interpreted to represent the amount the firm could raise at the required rate of return (10%), in addition to the initial cash outlay (Rs.2500), to distribute immediately to its shareholders and by the end of the projects’ life to have paid off all the capital raised and return on it.

Acceptance Rule

It should be clear that the acceptance rule using the NPV method is to accept the investment project if its net present value is positive (NPV>0) and to reject if the net present value is negative (NPV<0). npv="0.">

Ø Accept NPV > 0

Ø Reject NPV <>

Ø May accept NPV = 0

The NPV method can be used to select between mutually exclusive projects; the one with the higher NPV should be selected. Using the NPV method, projects would be ranked in order of net present values; that is, first rank will be given to the project with highest positive net present value and so on.

Evaluation of the NPV Method

NPV is the true measure of an investment’s profitability. The NPV method, therefore, provides the most acceptable investment rule. First, it recognizes the time value of money-a rupee received today is worth more than a rupee received tomorrow. Second, it uses all cash flows occurring over the entire life of the project in calculating its worth. The NPV method relies on estimated cash flows and the discount rate rather than any arbitrary assumptions, or subjective considerations. Third, the discounting process facilitates measuring cash flows in terms of present values; that is, in terms of current rupee. Therefore, the NPVs of projects can be added. For example , NPV (A+B)=NPV(A)+NPV(B). This is called the value-additivity principle, and it implies that if we know the NPV’s of separate projects, the value of the firm will increase by the sum of their NPV’s. we can also say that if we know values of separate assets, the firm’s value can simply be found by adding their values. The value-additivity is an important property of an investment criterion because it means that each project can be evaluated, independent of others, on its own merit. We will see later on that the value-additivity principle is not applicable in the alternative investment criteria. Fourth, the NPV method is always consistent with objective of maximizing the shareholders wealth. This is the greatest virtue of method.

The NPV method is easy to use if forecasted cash flows and the discounted rate are known. In practice, it is quite difficult to obtain the estimates of cash flows due to uncertainty and to precisely measure the discount rate. Further, Precaution needs to be applied in using the NPV method when alternative projects with unequal lives, or under funds constraint are evaluated.

It should be noted that the ranking of investment projects as per the NPV rule is not independent of the discount rates. Let us consider 2 projects- A & B- both costing Rs. 50 each. Project A returns Rs.100 after 1 year and Rs.25 after 2 years. On the other hand, project B returns Rs.30 after 1 year and Rs.100 after 2 years. At discount rate of 5 per cent and 10 per cent, the NPV of projects and their ranking are as follows

_____________________________________________________________

NPV at 5% Rank NPV at 10% Rank

Project A 67.92 II 61.57 I

Project B 69.27 I 59.91 II_______

It can be seen that the project ranking is reversed when the discount rate is changed from 5 per cent to 10 per cent. The reason lies in the cash flow patterns. The impact of the discounting becomes more severe for the cash flow occurring later in the life of the project; the higher the discount rate, the higher would be the discounting impact. In the case of Project B, the larger cash flows come later in the life. Their present value will decline as the discount rate increases.

Merits:

v Considers all cash flows.

v True measure of profitability. ·

v Based on the concept of the time value of money.

v Satisfies the value-additivity principle (i.e., NPV’s of two or more projects can be added).

v Consistent with the shareholders’ wealth maximization (SWM) principle.

Demerits:

v Requires estimates of cash flows which is a tedious task.

v Requires computation of the opportunity cost of capital which poses practical difficulties.

v Sensitive to discount rates.

INTERNAL RATE OF RETURN (IRR)

The IRR is the break-even discount rate. It calculates Break-even, IRR calculates an alternative cost of capital including an appropriate risk premium.

The Internal Rate of Return (IRR) is the discount rate that generates a zero net present value for a series of future cash flows. This essentially means that IRR is the rate of return that makes the sum of present value of future cash flows and the final market value of a project (or an investment) equal its current market value.

Internal Rate of Return provides a simple ‘hurdle rate’, whereby any project should be avoided if the cost of capital exceeds this rate. Usually a financial calculator has to be used to calculate this IRR, though it can also be mathematically calculated using the following formula:

In the above formula, CF is the Cash Flow generated in the specific period (the last period being ‘n’). IRR, denoted by ‘r’ is to be calculated by employing trial and error method.

Internal Rate of Return is the flip side of Net Present Value (NPV), where NPV is the discounted value of a stream of cash flows, generated from an investment. IRR thus computes the break-even rate of return showing the discount rate, below which an investment results in a positive NPV.

A simple decision-making criteria can be stated to accept a project if its Internal Rate of Return exceeds the cost of capital and rejected if this IRR is less than the cost of capital. However, it should be kept in mind that the use of IRR may result in a number of complexities such as a project with multiple IRRs or no IRR. Moreover, IRR neglects the size of the project and assumes that cash flows are reinvested at a constant rate.

The Modified Internal Rate of Return (MIRR) is an other financial measure used to determine the attractiveness of an investment.

In IRR calculations, positive cash flows are assumed to be 'paid' instantly to the investor who can use them immediately to reinvest on a new project. But in reality, the positive cash flows are not paid instantly to the investors, but rather kept by the 'project management entity' (ie: venture capital firm, department owning the project...) until the end of the project.

Internal Rate of Return or IRR is often used in capital budgeting, it's the interest rate that makes net present value of all cash flow equal zero. Essentially, IRR is the return that a company would earn if they expanded or invested in themselves, rather than investing that money abroad.

The IRR is found by trial and error.

Where r = IRR

IRR of an annuity:

where:

Q (n,r) is the discount factor
I_o is the initial outlay
C is the uniform annual receipt (C₁ = C₂ =....= C_n).

Example:

What is the IRR of an equal annual income of $20 per annum which accrues for 7 years and costs $120?

= 6

From the tables = 4%

Economic rationale for IRR:

If IRR exceeds cost of capital, project is worthwhile, i.e. it is profitable to undertake. Now attempt exercise 6.4

Exercise 6.4 Internal rate of return

Find the IRR of this project for a firm with a 20% cost of capital:

YEAR	CASH FLOW
	$
0	-10,000
1	8,000
2	6,000

a) Try 20%
b) Try 27%
c) Try 29%

It calculates Break-even, IRR calculates an alternative cost of capital including an appropriate risk premium.

Disadvantages

IRR cannot not be use to rate mutually exclusive projects, Mutually exclusive are those where you have to choose one project not both. The IRR also cannot be use in the usual manner for projects that start with an initial positive cash inflow, like Deposit in Fixed account by Customer, intermediate cash flows are never reinvested or considered at the project's IRR, thus making IRR little edgy as compared to NPV.

Problems with using IRR

As an investment decision tool, the calculated IRR should not be used to rate mutually exclusive projects, but only to decide whether a single project is worth investing in.

Two mutually exclusive projects

In cases where one project has a higher initial investment than a second mutually exclusive project, the first project may have a lower IRR (expected return), but a higher NPV (increase in shareholders' wealth) and should thus be accepted over the second project (assuming no capital constraints).

IRR makes no assumptions about the reinvestment of the positive cash flow from a project. As a result, IRR should not be used to compare projects of different duration and with a different overall pattern of cash flows. Modified Internal Rate of Return (MIRR) provides a better indication of a project's efficiency in contributing to the firm's discounted cash flow.

The IRR method should not be used in the usual manner for projects that start with an initial positive cash inflow (or in some projects with large negative cash flows at the end), for example where a customer makes a deposit before a specific machine is built, resulting in a single positive cash flow followed by a series of negative cash flows (+ - - - -). In this case the usual IRR decision rule needs to be reversed.

If there are multiple sign changes in the series of cash flows, e.g. (- + - + -), there may be multiple IRRs for a single project, so that the IRR decision rule may be impossible to implement. Examples of this type of project are strip mines and nuclear power plants, where there is usually a large cash outflow at the end of the project.

In general, the IRR can be calculated by solving a polynomial equation. Sturm's Theorem can be used to determine if that equation has a unique real solution. Importantly, the IRR equation cannot be solved analytically (i.e. in its general form) but only via iterations.

A critical shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment. However, this is not the case because intermediate cash flows are almost never reinvested at the project's IRR; and, therefore, the actual rate of return (akin to the one that would have been yielded by stocks or bank deposits) is almost certainly going to be lower. Accordingly, a measure called Modified Internal Rate of Return (MIRR) is used, which has an assumed reinvestment rate, usually equal to the project's cost of capital.

Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over NPV. Apparently, managers find it easier to compare investments of different sizes in terms of percentage rates of return than by dollars of NPV. However, NPV remains the "more accurate" reflection of value to the business. IRR, as a measure of investment efficiency may give better insights in capital constrained situations. However, when comparing mutually exclusive projects, NPV is the appropriate measure.

In addition if the NPV of one project is higher than another and the other project has a higher IRR, then the cross over point method can be used to solve this dispute.

Cross Over Point > IRR = Accept project with higher NPV and if the Cross Over Point < irr =" Accept">

PROFITABILITY INDEX

Profitability index identifies the relationship of investment to payoff of a proposed project.

The ratio is calculated as follows:

(PV of future cash flows)- (PV initial investment) / (PV Initial investment) = Profitability Index

OR

NPV / Initial Investment = Profitability Index

Profitability Index is also known as Profit Investment Ratio, abbreviated to P.I. and Value Investment Ratio (V.I.R.). Profitability index is a good tool for ranking projects because it allows you to clearly identify the amount of value created per unit of investment, thus if you are capital constrained you wish to invest in those projects which create value most efficiently.

A ratio of one is logically the lowest acceptable measure on the index. Any value lower than one would indicate that the project's PV is less than the initial investment. As values on the profitability index increase, so does the financial attractiveness of the proposed project.

Rules for selection or rejection of a project:

1) If PI > 1 then accept the project.

2) If PI <>

NON-DISCOUNTED CASH FLOW CRITERIA

PAY-BACK PERIOD METHOD

The term Pay-Back (or put out or pay off) Refers to the period in which the project will generate the necessary cash to recoup the initial investment. For example, if a project requires Rs. 20,000 as initial investment and it will generate an annual cash inflow of Rs. 5,000 for 10 years, the pay-back period will be

Pay-Back Period = Initial Investment

Annual Cash Inflow

= Rs. 20,000

Rs. 5,000

= 4 years.

The annual cash inflow is calculated by taking into account the amount of net income on account of the asset or project before depreciation but after taxation. The income so earned, if expressed as a percentage of initial investment, is termed as “unadjusted rate of return”. In the above case, it will be calculated as follows:

Unadjusted rate of return = Annual Return X 100

Initial Investment

= Rs. 5,000 X 100

Rs. 20,000

= 25%

Uneven cash inflows:

The cash inflows always may not be same. The cash flow each year may be different. In such a case cumulative cash inflows will be calculated and by interpolation, the exact pay-back period can be calculated. Foe e.g., if the project requires an initial investment of Rs. 20,000 and the annual cash inflows for 5 years are Rs. 6,000, Rs. 8,000, Rs. 5,000, Rs. 4,000 and Rs. 4,000 respectively. The pay-back period will be calculated as follows:

Year Cash Inflows Cumulative Cash Inflows

1 Rs. 6,000 Rs. 6,000

2 8,000 14,000

3 5,000 19,000

4 4,000 23,000

5 4,000 27,000

The above table shows that in 3 years Rs. 19000 has been recovered. Rs. 1,000 is left out of initial investment. In the fourth year the cash inflow is Rs. 4,000. It means the pay-back period is between 3 to 4 years, ascertained as follows:

Pay-Back Period = 3years + 1,000

4,000

= 3.25 years

Accept-Reject Criterion

The pay-back period can be used as a criterion to accept or reject an investment proposal. A project whose actual pay-back period is more than what has been pre-determined by the management will be straightaway rejected. The fixation of the minimum acceptable pay-back period is generally done by taking into account the reciprocal of the cost of capital. For example, if the cost of capital is 20% the maximum acceptable pay-back period would be fixed at 5 years. This can be termed as cut-off point. Usually projects having a pay-back of more than 5 years are not entertained because of greater uncertainties.

The pay-back period can also be used as a method of ranking in case of mutually exclusive projects. The projects can be arranged in ascending order according to the length of their pay-back periods. The project having the shortest pay-back period or highest unadjusted rate of return will be preferred provided it meets the minimum standard that has been established. For example, if the pay-back period has been fixed as 4 years, and a project A has a pay-back period of 3 years and project B has of 4 years, project A will be preferred.

Merits

The pay-back method has the following merits.

1. The method is very useful in the evaluation of those projects which involve high uncertainty, political instability, rapid technological development of cheap substitutes, etc., are some of the reasons which discourage one to take up project having long gestation period. Pay-Back method is useful in such cases.

2. The method makes it clear that no profit arises till the pay-back period is over. This helps new companies in deciding when they should start paying dividends.

3. The method is simple to understand and easy to work out.

4. The method reduces the possibility of loss on account of obsolescence as the method prefers investment in short term projects.

Demerits

The method has the following demerits.

1. The method ignores the returns generated by a project after its pay-back period. Projects having long gestation period will never be taken up if this method is followed though they may yield high returns for a long period.

e.g. Project A Project B

Initial Investment Rs. 10,000 Rs. 10,000

Cash Inflows:

Year 1 4,000 3,000

2 4,000 3,000

3 2,000 3,000

4 - 3,000

5 - 3,000

Pay-Back Period 3 yrs. 3.33 yrs.

In the above case Project A has a shorter pay-back period and therefore it should be preferred over B. But this may not be rational decision since project B continues to give return after the pay-back period which in fact has been completely ignored. As a matter of fact, on the whole Project B is more profitable as compared to Project A.

2. The method does not take into account the time value of money. In other words, it ignores the interest which is an important factor in making sound investment decisions. A rupee tomorrow is worth less than a rupee today. The following example makes this point clear.

Cash Inflows

Year Project A Project B

1 Rs. 10,000 Rs. 20,000

2 10,000 4,000

3 10,000 24,000

The pay-back period is 3 years in both cases. However, project A should be preferred as compared to project B because of speedy recovery of initial investment.

Suitability

In spite of the above limitations, pay-back method can be profitably used in each of the following cases:

1. Hazy long-term outlook: Where on account of political or other conditions, long-term outlook (say exceeding 3 yrs.) seems to be quite hazy, pay-back method is appropriate.

2. Firms suffering from liquidity crises: A firm which suffers from liquidity crises is more interested in quick return on funds rather than profitability. Pay-back method suits them most because it also emphasizes on quick recovery of funds.

3. Firms emphasizing short-term earning performance: Pay-back method is also suitable for a firm which emphasizes on short-term earning performance of the firm rather its long-term growth.

It may therefore, be said that pay-back period is a measure of liquidity of investment rather than their profitability. It should more appropriately be treated as a constraint to be satisfied than as a profitability measure to be maximized.

DISCOUNTED PAY-BACK PERIOD METHOD

The method discussed above is traditional Pay-back period method. However in order to overcome the criticism that this method does not take into account the time value of money, the discounted pay-back period method is recommended. In case of this method, the present value of cash inflows arising at different time intervals at the desired rate of interest (depending upon the cost of capital) are found out. The present values so calculated are now taken as the real cash inflows for determination of the pay-back period.

ACCOUNTING OR AVERAGE RATE OF RETURN (ARR)

According to this method, the capital investment proposals are judged on the basis of their relative profitability. For this purpose, capital employed and related incomes are determined according to commonly accepted accounting principles and practices over the entire economic life of the project and then the average yield is calculated. Such a rate is termed as Accounting Rate of Return. It may be calculated according to any of the following methods:

(i) Annual Average Net Earnings X 100

Original Investment

(ii) Annual Average Net Earnings X 100

Average Investment

Average Annual Net Earnings is the average of the earnings (after depreciation and tax) over the whole of the economic life of the project.

Average Investment can be calculated according to any of the following methods:

(a) Original Investment

2

(b) Original Investment – Scrap Value of the Asset

2

(c) Original Investment + Scrap Value of the Asset

2

(d) Original Investment-Scrap Value + Addl. Net + Scrap

2 Working Capital Value

Out of the 4 methods of calculating average investment, method (d) seems to be theoretically more logical on account of the following reasons:

(i) Presuming that depreciation is charged according to fixed installment method, the average investment in the asset is only 50% of the original cost less scrap value.

(ii) The amount required for additional net working capital (CA-CL) remains tied up during the lifetime of the asset. Its entire amount is therefore a part of investment in the asset.

(iii) Scrap Value is realized only at the end of the life of the asset. Depreciation is charged on the asset after deducting scrap value. Hence, the whole amount of scrap value remains tied up in the project throughout its lifetime.

Accept/ Reject Criterion

Normally, business enterprises fix a minimum rate of return. Any project expected to give a return below this rate will be straightaway rejected.

In case of several projects, where a choice has to be made, the different projects may be ranked in the ascending or descending order of their rate of return. Projects below the minimum rate of return will be rejected. In case of projects giving a higher rate of return than minimum rate, obviously projects giving a higher rate of return will be preferred over those giving a lower rate of return.

Advantages

The following are the advantages of this method.

1. The method takes into account savings over the entire economic life of the asset. Hence, it provides a better comparison of the projects as compared to the pay-back method.

2. The method embodies the concept of ‘net earnings’ while evaluating a capital investment project which is absent in case of all other methods.

Disadvantages

The method suffers from the following disadvantages.

1. The method does not take into account the time value of money. Thus, it has the same fundamental defect as that of the pay-back method.

2. There are different methods to calculate the Accounting Rate of Return due to diverse concepts of investments as well as earnings. Each method gives different results. This reduces the reliability of the method.

On account of the above disadvantages, the Accounting Rate of Return Method is not much in use these days.