Summary
Summary Financial of Financial and Project Management (440026-B-6)
- Course
- Institution
Summary of lectures including assignments from the slides and bonus assignments with solutions.
[Show more]
Seller
Follow
marloes5
Reviews received
Content preview
Financial managementLecture 1
1. Understand and explain the difference between the three core disciplines in
financial management (i.e., finance, management accounting, and financial
accounting);
2. Define ‘capital budgeting’ and the time value of money;
3. Evaluate the connection between free cash flows and profits;
4. Assess investment projects based on a range of techniques (i.e., accounting rate of
return, payback period, net present value, and internal rate of return);
5. Interpret the differences between these assessment techniques.
1. Capital budgeting
a. Capital budgeting, free cash flows, and profits
Capital budgeting (investment appraisal) = the process in which an organization determines
whether investments (such as opening a new branch, replacing a machine, investing in R&D)
are worth pursuing
● Assessing whether it is worthwhile to invest in a particular project
● Choosing between different projects
● Replacement vs. expansion investments
Free cash flow = Difference between:
● Cash inflows, generated by sales and other income directly resulting from the investment
● Cash outflows, generated by purchasing of resources related to the investment, rent,
corporate taxes, etc.
● Includes initial investment and disinvestment (=Residual value of the investment)
Free cash flow Period profit after tax + depreciation – investments +
disinvestments
Start of project Free cash flow = - investment
During project Free cash flow = period profit after tax + depreciation
End of project Free cash flow = period profit after tax + depreciation +
disinvestment
Example
You are the leader of a project on manufacturing eco-friendly cutlery. You have
gathered the following data regarding your machinery in the coming year:
● Sales: €3,750
● Operating costs: €1,250
● Operating costs do not include depreciation
, ● Depreciation: €450
● The tax rate is 25%
● In the coming year, there are no other (dis-)investments
Free cash flow = period profit after tax + depreciation
● So, first calculate period profit after tax
● Profit before tax : 3,750 (sales) – 1,250 (operating costs) - 450 (depreciation) =
2,050
● Profit after tax: 2,050 – 0.25*(2,050) = 1,537.50
● Add depreciation to determine the free cash flow: 1,537.50 + 450 = 1,987.50
Free cash flow = € 1,987.50
Period profit (‘accounting income’, ‘net income’) = Difference between period sales and costs
associated with an investment
Depreciation = Intention: Distribute costs of assets over the years in which the asset is used
b. Assessment based on period profit: accounting rate of return
Accounting Rate of Return (ARR):
● Compare with ‘weighted average cost of capital’ (WACC):
● Average cost against which a company can attract capital
● Ignores distribution of free cash flows over duration of the project
ARR 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑝𝑟𝑜𝑓𝑖𝑡
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 (𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒)
Average profit Σ Period profits / Duration in years
Average invested capital (average book value) (Initial investment + Residual value)/2
c. Assessment based on free cash flows: payback period
Payback Period:
● Period between the original investment and the cash inflows up to the amount of the
investment
● Very crude measure, only partially accounts for timing of free cash flows, does
not account for free cash flows after the payback period, and no clear cut-off point\
● Not very suitable for projects
d. Assessment based on free cash flows, taking into account time value of money: net present
value and internal rate of return
Time value of money:
Future value If you save €1,000 for 4 years @ 5%
Compound interest rate (compound interest), its future value is:
€ 1,000*(1.05*1.05*1.05 *1.05) =
, € 1,000*(1.05)4= € 1,215.51
Present value If you want to receive €1,000 in 4 years @
Discount rate 5% (discount rate), its present value would
be:
€ 1,000/(1.05*1.05*1.05*1.05) =
€ 1,000/(1.05)4= € 822.70
Net Present Value:
Present value of all expected future free cash flows, including the initial investment
(disinvestment is included in free cash flow of final year)
● Discount rate: WACC
● If NPV > 0 àproject warrants further consideration!
Example
You are the CEO of a well-known firm of architects. At the eve of the firm’s 50th anniversary,
you have asked two teams of employees to pitch a (multi-year) project to put the firm in the
spotlight. Calculate the NPV of both projects (WACC: 8%).
A. Pop-up exhibit in gallery in busy shopping street (3 years)
B. 3D-prints of most-famous accomplishments, to be sold (4 years)
- NPVA(€ 1,000)
= -500 + 150/(1.08) + 200/(1.08)2+ 400/(1.08)3
= -500 + 138.89 + 171.47 + 317.53
= 127.89
- NPVB(€ 1,000)
= -300 + 100/(1.08) + 100/(1.08)2+ 100/(1.08)3 + 200/(1.08)4
= 104.72
- NPV of both projects is > 0, so both warrant further consideration
- NPVA > NPVB, so project A should be preferred
Example
A real estate developer has the opportunity to buy a piece of land. His desired return (WACC)
is 14% in not more than 4 years. The initial investment is estimated at € 340,000. The free
cash flows in the first four years are as follows:
• Year 1: € 50,000
• Year 2: € 55,000
• Year 3: € 55,000
• Year 4: € 415,000
Calculate NPV by determining the sum of the initial investment and the expected discounted
future free cash flows:
• NPV = -340 + 50/(1.14) + 55/(1.14)2+ 55/(1.14)3+ 415/(1.14)4
= 29.017
Internal rate or Return (IRR)
Discount rate where the NPV of a project equals zero
● If IRR > WACC (interest rate), project is acceptable
, ● To determine IRR: trial and error OR just by Excel
Example
- IRRA(€ 1,000)
0 = -500 + 150/(1+i) + 200/(1+i)2+ 400/(1+i)3
i = 0.19
- IRRB(€ 1,000)
0 = -300 + 100/(1+i) + 100/(1+i)2+ 100/(1+i)3
+ 200/(1+i)4
i = 0.21
- IRR of both projects is > WACC (8%), so both warrant further consideration
- IRRB > IRRA, so project B should be preferred
Net Present Value (NPV) vs. Internal Rate of Return (IRR)
● NPV and IRR sometimes give seemingly contradictory results
● NPV does not measure the rate of return and tends to favor projects with a longer
duration
● IRR assumes that free cash flows received before the end of the project can be
investedduring the remaining period with a return equal to the IRR. For high IRRs, this is
dubious.
● In practice, people may prioritize NPV (at least greater than zero) and then consider IRR.
e. Assessment of assessment techniques
Uncertainty = Future free cash flows are only estimates, not known in advance
Sensitivity analysis= Analysis of the effect of change in sales/costs on profit and cash flows
E.g.: optimistic and pessimistic scenarios
Risk premium = Adding a premium to the discount rate
2. Working capital management
Working capital = Resources available to the organization for day-to-day operations
● Organizations’ need a sufficient level
● Liquidity; financial health of the organization
● Investment opportunities; operational health of the organization
● BUT... not too much! → Efficient management of financial resources
The benefits of buying summaries with Stuvia:
Guaranteed quality through customer reviews
Stuvia customers have reviewed more than 700,000 summaries. This how you know that you are buying the best documents.
Quick and easy check-out
You can quickly pay through credit card or Stuvia-credit for the summaries. There is no membership needed.
Focus on what matters
Your fellow students write the study notes themselves, which is why the documents are always reliable and up-to-date. This ensures you quickly get to the core!
Frequently asked questions
What do I get when I buy this document?
You get a PDF, available immediately after your purchase. The purchased document is accessible anytime, anywhere and indefinitely through your profile.
Satisfaction guarantee: how does it work?
Our satisfaction guarantee ensures that you always find a study document that suits you well. You fill out a form, and our customer service team takes care of the rest.
Who am I buying these notes from?
Stuvia is a marketplace, so you are not buying this document from us, but from seller marloes5. Stuvia facilitates payment to the seller.
Will I be stuck with a subscription?
No, you only buy these notes for $7.07. You're not tied to anything after your purchase.
Can Stuvia be trusted?
4.6 stars on Google & Trustpilot (+1000 reviews)
62491 documents were sold in the last 30 days
Founded in 2010, the go-to place to buy study notes for 14 years now