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**com/abstract=2028640
**

* Bartłomiej Cegłowski, assistant professors at the Department of Finance at Kozminski University in

Warsaw, ceglos@kozminski.edu.pl

** Paweł Mielcarz, assistant professors at the Department of Finance at Kozminski University in

Warsaw, pmielcarz@kozminski.edu.pl

Application of break-even revenue concept in assessment of

investments generating time-limited free cash flows

Bartłomiej Cegłowski*

Paweł Mielcarz**

Electronic copy available at: http://ssrn.com/abstract=2028640

2

1. Introduction

The statement that good investment decisions are extremely important for the success of

a company in the long run (Bennouna et al., 2010) seems to be especially valid in the

time of crisis which proves to be really effective in exposing the consequences of bad

investment decisions. This statement also brings the issue of evaluation and selection of

investment projects into the spotlight of management process. Projects evaluation is

associated with the process of forecasting the free flows generated by the investment. It

is a time-consuming activity, requiring performance of a number of analyses concerning

revenues, expenses, working capital, capital expenditure and sources of financing. It

may appear that forecasting expected revenues is an operation particularly exposed to

risk and manipulation. Therefore, instead of spending too much time for prediction of

future demand and for formulating market strategies, it is worth to look for a tool which

is able to indicate the level of revenue necessary for achieving the expected rate of

return on the invested capital.

The aim of the article is to present a new method of investment projects evaluation,

which facilitates the process of value creation analysis and generates an easily-

interpretable information for non-experts of financial analysis. Some limited versions of

the approach have been already presented to some extent in reference books (Nita 2007;

Cegłowski, Mielcarz, 2012).

1

However, this article provides a version extended by new

elements and formalized in the form of closed formulas facilitating the method’s

application. The presented solution conforms with the rules of value based management.

Its use in the preliminary phase of the analysis allows calculation of minimum revenue

which is necessary to generate the required rate of return in the specified time horizon.

Thus this method helps to recognise projects which do not hold out the prospect for

creating a positive net present value. The information about the minimum revenue is

easy to present – after small modifications – in a more approachable and understandable

way to decision makers, e.g. as the number of customers per day, daily sales, minimum

occupancy rate or market share, necessary to achieve the expected rate of return on the

invested capital.

2. Value based management analytical tools

1

Under the name of “Value creation threshold” or “Financial Break-Even Point”

3

There are numbers of tools created as part of theory and practice, which aim is to

support management’s decision-making processes. Taking into account their purposes,

two main groups of analytical tools can be singled out. The first consists of financial

measures used in monitoring effectiveness of value based management (Merchant;

2006). This group includes economic value added (EVA of Stern Stewart & Co.), cash

flow return on investment (CFROI of Value Associates), total business return (TBR of

Boston Consulting Group), economic profit (EP of McKinsey & Co.) and shareholder

value added (SVA of LEK/Alcar). Considering the frequency of appearance in reference

books, the interest among researchers, as well as the commonness of corporate

application, the economic value added can be recognized as the most popular tool

2

.

The second group consists of tools supporting the evaluation of investment decisions.

The majority of studies shows that in corporate practice, the tools which are used most

often base on the concept of net present value (Jog and Srivastava: 1995, Graham and

Harvey 2001, Ryan and Ryan, 2002). Yet, despite the dominance of discounting

methods, the method of payback period is also popular (PP – Payback Period; Graham,

Harvey 2001). Studies by K. Bennouna, G. Meredith , T. Marchant reveal that almost as

many as 79% of the surveyed companies still use the tool (Bennouna et al., 2010). It

seems that this method is so popular mainly due to its simplicity and easiness of

interpretation.

The clarity of a method itself, as well as acceptance among managers are, in fact,

particularly significant issues. The decision makers not only have to know the method

of calculation of a given measure, but they should most of all be able to understand the

results obtained (Merchant 2006). Without the correct understanding of the essence of

the tool and the results of the performed analyses, making a right investment decision is

much hindered.

3. Calculation of break-even revenue for projects generating perpetual cash flow

3

Break-even is the sales (in quantity or value) where costs of s company or a project are

covered by its revenue. The simplest way to calculate break-even revenue is by using

the following formula:

2

In the 90s of the 20

th

century, Stern Stewart implemented management systems based on EVA in over

700 companies (see: www.sternstewart.com/?content=history&p=1990s)

3

This part of the article discusses the concept of value creation break even, described in reference books

(Nita, 2007). The tools developed and described by the authors in part four of the article base on the

assumptions of value creation break even, thus the convention of discussing new solution in reference to

the already known ones has been adopted.

4

BEP

w

=

FC

t

+A

t

H

%

(1)

where: BEP

w

– value break-even point,

FC

t

– fixed costs without amortization, incurred in the time period t,

A

t

– amortization costs incurred in the time period t,

M

%

– gross margin in percents, calculated as the difference between sales and

variable costs, referred to the value of sales.

The revenue guaranteeing the achievement of the required operational profit is

calculated on the basis of formula 2:

BEP

w

=

FC

t

+A

t

+Z

t

H

%

(2)

where: Z

t

– the value of the expected operational profit in period t

Calculation of the break-even according to formulas 1 and 2 does not lead to

information useful for the evaluation of investment projects, for it omits the costs and

value of the employed capital necessary to finance the fixed assets and net working

capital. These areas are included in the concept of economic profit, described often as

economic value added (EVA) (Maćkowiak 2009). Its value can be calculated based on

the following formula:

[ ]

1 −

× − =

t t t

CI WACC NOPAT EVA (3)

where: NOPAT

t

– net operating profit after tax in the period t,

WACC

t

- weighted average cost of capital,

CI

t-1

– capital invested; capital employed in financing fixed assets and working

capital in period t-1

Net operating profit after tax value is calculated using formula 4:

N0PAI = (P × H%−FC −A) × (1 −I) (4)

where: P – revenue,

T – tax rate.

5

According to the fundamental assumption of EVA concept, a company does not

generate, nor does it lose value for its shareholders in a given period in a situation when

the achieved EVA equals 0. Assuming in the case of formula 3 that in a given period the

EVA equals 0 and substituting the profit (Z) with the value of NOPAT, the following

formula can be presented as:

(5)

where: BEP

s

- value of break-even revenue ensuring EVA at 0 level

Formula 5, allowing for the calculation of break-even revenue, has already been

presented in reference books (Nita 2007). In practice, this formula lets defining the

value of revenue ensuring the achievement of zero NPV from investment projects with

the assumption that the free cash flow generated by the projects will be fixed and

perpetual. This fact can be arrived at by analyzing one of the formulas for the

calculation of NPV, which assumes the use of future EVAs for this purpose:

NPI =

EIA

t

(1 +wACC)

t

∞

t=1

(6)

Taking into account that formula 5 allows for determining of the revenue resulting in a

zero EVA, it stems from formula 6 that this revenue also allows for the achievement of

a zero NPV from a project in the conditions of fixed perpetual EVA.

To increase value of a company, NPV positive project should be implemented. A zero-

level NPV project means that the project allows for the achievement of rate of return

expected by the investors, but it does not increase value of the company. In the

conditions of full financial market efficiency, taking a decision on investing in a zero

NPV project will not affect the change of value of the entity running the project. Thus,

it is a break-even value with which the implementation of a project is neutral from the

owners’ perspective.

The financial literature (Fernandez 2007) points out that there are nine techniques of

calculation of free cash flow and discount rates, which – when applied properly –

should give an identical net present value from a project. These methods include both

the calculation basing on future economic values added (formula 6), as well as the

future free cash flow for firms. One disadvantage of NPV calculation basing on EVA

( )

( ) T M

WACC CI T A FC

BEP

t t

S

t

− ×

× + − × +

=

−

1

) 1 (

%

1

6

technique is the relatively low recognisability of such approach in the environment of

analysts and decision makers (Ryan and Ryan, 2002). The best known and most used

approach in terms of the process of evaluation of investment projects is calculation

based on FCFF formula. The NPV calculation formulas for the projects generating free

cash flow for firms in the required time period are as follows:

NPI = −CI

t-1

+

FCFF

t

(1 +wACC)

t

n

t=1

(7)

where: FCFF

t

= N0PAI

t

+A

t

−CI

t

CI = capital investments (I) + working capital investments (WCI)

4. Break-even revenue for projects generating time-limited free cash flow

The concept of break-even revenue for the projects generating time-limited free cash

flow, which will allow for the achievement of the required rate of return within a given

period – the NPV equalling zero – is a combination of four tools used for financial

analysis. These include:

• break-even,

• economic profit (economic value added),

• discounted payback period,

• present annuity value.

The formula for the present value of annuity is as follows:

PI = PHI

1 −(1 +r)

-n

r

(8)

where: PV – present value

PMT – the amount of each payment

r – interest rate in percent, updating annuity payments

n – number of periods in annuity

In order to determine the minimum yearly values of EVA, ensuring a zero NPV in the

required time period, it is to be assumed that:

1. PV equals the value of the capital invested in the implementation of the project

(PV = CI)

7

2. r equals the value of the weighted average cost of capital, the expected rate of

return on the investment project (r = WACC)

3. n is the number of periods of the project

4. PMT equals the yearly value of EVAs necessary to be achieved in the required

time (n), so that the present value of EVA becomes equal with the value of the

capital invested in the implementation of the project (CI)

Next, we have to reformulate formula 8 with regard to EVA (PMT) and substitute the Z

from formula 2 with the obtained formula. By means of appropriate reformulations we

arrive at formula 9 which allows us to calculate the value of revenue (BEP

E

), with

which in a given period the expenditures for the implementation of investments and the

present value of the related arising cash flow are equal. In addition, this model is

characterized by the following assumptions:

1. residual value after the project is finished equals 0

2. there is a reinvestment of the amount equal to the costs of amortization

incurred in subsequent years.

BEP

L

=

FC +A

H

%

+

CI ×

wACC

1 −(1 +wACC)

-n

(1 −I) × H

%

(9)

where: BEP

E

– break-even value of revenue ensuring the achievement of a zero NPV

for the project generating cash flow in a specified time horizon

Considering the fact that residual value may be different than zero is associated with the

necessity to decrease the value of the capital invested by the present value of expected

residual value. An appropriate correction is included in formula 10:

BEP

L

=

FC +A

H

%

+

_CI −

RI

(1 +wACC)

n

] ×

wACC

1 −(1 +wACC)

-n

(1 −I) × H

%

(10)

The elimination of the assumption of necessity to reinvest means equal to the value of

amortization involves the necessity to eliminate the break-even of amortization from

calculation and to include the present amount of discounted tax shield in calculating the

break-even value of revenue. The formula, after proper reformulations, is as follows:

8

BEP

L

=

FC

H

%

+

_CI −

RI

(1 +wACC)

n

] ×

wACC

1 −(1 +wACC)

-n

−A × I

(1 −I) × H

%

(11)

where: RV – residual value of the project

It should be emphasized that the substitution of the cost of capital (WACC) with the

target value of the internal rate of return (IRR

T

) gives the possibility of estimating the

value of revenue which allow for the achievement of IRR from the project on the

required level. An appropriate formula is shown below (formula 12):

BEP

L1

=

FC

H

%

+

_CI −

RI

(1 +IRR

1

)

n

] ×

wACC

1 −(1 +IRR

1

)

-n

−A × I

(1 −I) × H

%

(12)

where: BEP

ET

– break-even value of revenue ensuring the achievement of IRR on the

required level for the project generating cash flow in a specified time horizon

In a similar way, we can arrive at a formula which allows for calculation of the value of

break-even revenue ensuring the value of NPV equalling zero, assuming that the free

cash flow grows at a constant rate. In such case, in order to calculate the value of EVA

that has to be achieved in the first period of projection, we have to use the formula for

the present value of annuity changing at the pace g. The formula is as follows:

PI = PH× (1 +g) × _

1 −

(1 +g)

n

(1 +r)

n

r −g

_ (13)

where: PM – the amount of the first payment of the annuity

g – the rate of change in payments of subsequent elements of the annuity

In order to determine the minimum value of EVA in the first period, which – changing

at the rate of g – allows for the achievement of a zero NPV within the required time

horizon, it is to be assumed that:

1. PV equals the value of the capital invested in the implementation of the project

(PV = CI)

9

2. r equals the value of the weighted average cost of capital, the expected rate of

return on the investment project (r = WACC)

3. n is the number of periods of the project

4. PM equals the value of EVA achieved in the first year, which – after changes at

the rate of g – ensures the achievement in a specified period (n) a present value

equal to the value of capital invested in the implementation of the project (CI)

After reformulation of the formula with regard to EVA and substituting the profit (Z)

from formula 2 with it, we arrive at the following formula:

BEP

L

=

FC

H

%

+

CI −

RI

(1 +wACC)

n

(1 +g) × _

1 −

(1 +g)

n

(1 +wACC)

n

wACC −g

_

−A × I

(1 −I) × H

%

(14)

5. Numerical illustration

The correctness of the presented formula can be illustrated with a simple example. Let

us assume that an investor wants to invest 12 m. zlotys in a plot and a production hall.

For running operations he also needs working capital in the amount of 0.5 m. zlotys,

which makes the capital invested (CI), necessary to implement the investment, equal at

least 12.5 m. zlotys. The capital is acquired, with the weighted average cost of capital

(WACC) at the level of 11%. Incremental fixed costs without amortization (FC) of the

project are equal 2 m. zlotys per year. The average gross margin in percents (M

%

) will

probably amount to 22%. The yearly costs of amortization are expected to be around 2.4

m. zlotys. The company pays a 19% income tax (T). According to estimations, it

appears that after the period of five years, when the investor plans to end his operations

and sell the acquired assets, the market value of the estate (after taxation) will probably

amount to around 7 m. zlotys. The investor assumes that the investment should give

back the invested capital, increased by the required rate of return within 5 years, and

that in subsequent years the replacement investments are made in the amount equal to

the costs of amortisation. Taking into account the following data, the gross receipts

ensuring the successful realization of the plans amount to 32.672 m. zlotys. The result

was arrived at by including the data into formula 10:

10

BEP

L

=

2 +2.4

u.22

+

_12.S −

7

(1 +u.11)

5

] ×

u.11

1 −(1 +u.11)

-n

(1 −u.19) × u.22

BEP

L

= S2.672

The result means that assuming fixed gross revenues in the amount of 32.672 m. zloty

in each of the forthcoming 5 years the project will give to the investors rate of return on

the level 11%.

Table 1 presents calculation of the value of free cash flow (according to formula 7) and

NPV of the presented project with the assumption that the value of revenues is equal to

the value of break-even revenue (formula 10).

Table 1. Calculation of NPV of the presented project with the assumption of gross

receipts on the level of break-even revenue

N 0 1 2 3 4 5

P 32.67 32.67 32.67 32.67 32.67

M% 22% 22% 22% 22% 22%

- FC 2.00 2.00 2.00 2.00 2.00

- A 2.40 2.40 2.40 2.40 2.40

= NOPAT 2.26 2.26 2.26 2.26 2.26

+ A 2.40 2.40 2.40 2.40 2.40

- WCI 0.50

- I 12.00 2.40 2.40 2.40 2.40 2.40

+ RV 7.00

= FCFF + RV -12.50 2.26 2.26 2.26 2.26 9.26

WACC 11.0%

DFCFF+DRV -12.50 2.03 1.83 1.65 1.49 5.49

Cum DFCFF -12.50 -10.47 -8.63 -6.98 -5.49 0.00

IRR 11%

NPV 0.00

Source: own work

NPI

11%

= −12.S +

2.26

(1 +u.11)

+

2.26

(1 +u.11)

2

+

2.26

(1 +u.11)

3

+

2.26

(1 +u.11)

4

+

9.26

(1 +u.11)

5

11

NPI

12%

= u

As it has already been mentioned, the application of formula 10 results in the

assumption that in each year of projection, the replacement investments are equal with

the value of amortization. However, such approach is incorrect in a situation when the

project is not characterized by the necessity for any replacement investment. In such

case, formula 12 should be used to calculate the break-even revenue:

BEP

L

=

2

u.22

+

_12.S −

7

(1 +u.11)

5

] ×

u.11

1 −(1 +u.11)

-n

−2.4 × u.19

(1 −u.19) × u.22

BEP

L

= 19.2u

Table 2. NPV calculation with the assumption of gross receipts on the level of break-

even revenue and no additional investments

n 0 1 2 3 4 5

P 19.20 19.20 19.20 19.20 19.20

M% 22% 22% 22% 22% 22%

- FC 2.00 2.00 2.00 2.00 2.00

- A 2.40 2.40 2.40 2.40 2.40

= NOPAT -0.14 -0.14 -0.14 -0.14 -0.14

+ A 2.40 2.40 2.40 2.40 2.40

- WCI 0.50

- I 12.00

+ RV 7.00

= FCFF + RV -12.50 2.26 2.26 2.26 2.26 9.26

WACC 11.0%

DFCFF+RV -12.50 2.03 1.83 1.65 1.49 5.49

Cum

DFCFF -12.50 -10.47 -8.63 -6.98 -5.49 0.00

IRR 11.0%

NPV 0.00

Source: own work

The IRR calculation presented in table 2 shows that formula 12 also allows for a correct

calculation of the value of break-even revenue ensuring the achievement of the expected

internal rate of return.

12

In addition, in order to verify the cohesion of the presented discussion, the value of

NPV has been calculated with the help of the model using EVA projection (formulas 3

and 6).

Table 3. NPV calculation with the assumption of gross receipts on the level of break-

even revenue and no additional investments

n 0 1 2 3 4 5

CIn 12.50 10.10 7.70 5.30 2.90

+ I 12.50 0.00 0.00 0.00 0.00 0.00

- A 2.40 2.40 2.40 2.40 2.40

= CIn+1 12.50 10.10 7.70 5.30 2.90 0.50

NOPAT -0.14 -0.14 -0.14 -0.14 -0.14

EVA 0.00 -1.52 -1.25 -0.99 -0.72 -0.46

RV EVA 6.50

D EVA+RV 0.00 -1.37 -1.02 -0.72 -0.48 3.58

NPV 0.00

Source: own work

NPI

11%

=

−1,S2

(1 +u,11)

+

−1,2S

(1 +u,11)

2

+

−u,99

(1 +u,11)

3

+

−u,48

(1 +u,11)

4

+

−u,46 +6,S

(1 +u,11)

5

NPI

11%

= u

It is worth to notice that EVA values decrease with subsequent years of projection. It is

a consequence of devaluation of the invested capital due to the lack of replacement

investments.

The illustration of calculations made with the use of formula 14 was developed with the

assumption that free cash flow grow by 3% per year:

BEP

L

=

2

u.22

+

12.S −

7

(1 +u.11)

5

(1 +u.uS) × _

1 −

(1 +u.uS)

5

(1 +u.11)

5

u.11 −u.uS

_

−2.4 × u.19

(1 −u.19) × u.22

13

Table 4. NPV calculation with the assumption of gross receipts on the level of break-

even revenue and no additional investments

N 0 1 2 3 4 5

P 18.19

M% 22%

- FC 2.00

- A 2.40

= NOPAT -0.32

+ A 2.40

- WCI 0.50

- I 12.00

+ RV 7.0

= FCFF -12.50 2.08

FCFF (1+g)^n +

RV -12.50 2.14 2.20 2.27 2.34 9.41

WACC 11.0%

DFCFF -12.50 1.93 1.79 1.66 1.54 5.58

Cum DFCFF -12.50 -10.57 -8.78 -7.12 -5.58 0.00

IRR 11.0%

NPV 0.00

Source: own work

6. Conclusion

The presented method allows for quick calculation of the scale of revenue with which a

given enterprise shall be profitable, covering not only operation costs, but also the costs

of capital. In relation to the already described methods, the solution takes into

consideration the finite time horizon of free cash flow gained thanks to investment. This

approach is not flawless, of course, and assumes a number of simplifications, e.g. the

constant level of revenue or the permanent pace of changes in the free cash flow. Still, it

makes it possible to discover if a given enterprise can be profitable in a required time

horizon quite fast. Practical application of this method in economy may also facilitate

communication between financial analysts and decision makers, since the latter of the

lack the appropriate expert knowledge in the area of methods of appraisal of investment

projects. The break-even revenue, unlike traditional NPV, is easily converted into

physical measures. At the same time, the formula enables further analyses, e.g. studying

the sensitivity to changing assumptions.

14

Literature

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making: evidence from Canada, „Management Decision” Vol. 48, No. 2, pp. 225 – 247.

Cegłowski B., Mielcarz P. (2012), Wykorzystanie koncepcji obrotu granicznego w

ocenie projektów podnoszących wartość przedsiębiorstwa, „Przegląd Organizacji”, No.

2, February, pp. 27-30.

Graham J.R., Harvey C.R. (2001), The Theory and Practice of Finance: Evidence from

the Field, „Journal of Financial Economics”, Vol. 60, May, pp. 187–243.

Jog V. M., Srivastava, A.K. (1995), Capital Budgeting Practices in Corporate Canada,

„Financial Practice and Education”, Vol. 5 No. 2.

Fernandez P. (2007), Valuing companies by cash flow discounting: ten methods and

nine theories, „Managerial Finance”, Vol. 33 No. 11. pp.853 - 876

Maćkowiak E. (2009), Ekonomiczna wartość dodana, PWE, Warszawa.

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Osborne M.J., A resolution to the NPV–IRR debate?, „The Quarterly Review of

Economics and Finance” 2010, Vol. 50

Ostaszewski J., Cicirko T., Kreczmańska-Gigol K., Russel P., Finanse spółki akcyjnej,

Difin, Warsaw 2009

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Business and Management” 2002, Vol. 8 No. 4

15

Application of break-even revenue concept in assessment of investments

generating time-limited free cash flows

Summary

In spite of the fact that capital budgeting methods are widely discussed in financial

literature, there are still difficulties with the theory implementation in practice. The

reasons for this situation are easy to identify. In case of the methods of preliminary

analysis (eg. payback period, break-even point) the very far-reaching simplification are

indicated. On the other hand the use of more advanced methods (e.g., NPV, EVA)

requires expertise in free cash flows and discount rates forecasting, the skills which are

not very common among managers responsible for investment decisions. The article

presents a method developed by the authors which combines different tools. The created

method gives an easy to interpret information about value of sales which guarantees

NPV equals 0 in a given period of analysis.

Keywords: break-even, payback period, NPV, EVA, WACC

Zastosowanie koncepcji progu rentowności w ocenie inwestycji generujących

ograniczone czasem wolne przepływy pieniężne

Streszczenie

Temat analizowania opłacalności inwestycji został szczegółowo opisany w literaturze

przedmiotu, wciąż występują jednak problemy z prawidłową implementacją teorii w

praktyce. Powody takiej sytuacji można stosunkowo łatwo zidentyfikować. W

przypadku metod zaliczanych do analizy wstępnej (np. okres zwrotu, próg rentowności)

zwraca się uwagę na zbyt daleko idące uproszczenia. Zastosowanie metod bardziej

zaawansowanych (np. NPV, EVA) wymaga z kolei specjalistycznej wiedzy z zakresu

prognozowania przepływów pieniężnych i stopy dyskontowej, której często nie

posiadają osoby ostatecznie podejmujące decyzje o realizacji bądź odrzuceniu

projektów inwestycyjnych. W artykule zaprezentowana została opracowana przez

autorów metoda, która pozwala wykorzystać zalety wymienionych narzędzi i przy

pomocy jednego wzoru wyznaczyć łatwą do interpretacji wartość przychodów, przy

16

których NPV w przyjętym do analiz okresie wyniesie 0, a więc finansujący otrzymają

zwrot z inwestycji na wymaganym poziomie.

Słowa kluczowe: próg rentowności, okres zwrotu, NPV, EVA, WACC

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