Ex-Ante

Project
Analysis
Internal Rate of Return (IRR),
Net Present Value (NPV),
Payback Period
Objectives
• To understand how business executives decide and evaluate
projects
• To improve business judgment and acumen when evaluating
project proposals or applications
• To use financial spreadsheet tools in evaluating viability of
investment proposals
• To be able to assess potential redundancy of incentives
Outline

• Why Firms Invest

• The Investment Analysis Process
• Review of Balance Sheet and Income Statement
• Time Value of Money
• WACC
• Free Cash Flow and Initial Investment Cost
• Investment Analysis Toolkit
• Assessing Redundancy through IRR, NPV, and Payback
 Ex-Ante vs. Ex-Post Analysis

Ex-Ante Ex-Post
• Before a decision is made • After the fact
• Before the event • After the event
• Analysis is based on forecasts or • Analysis is based on actual or
projection rather than actual historical results
results • Tool to use:
• Tools to use: • Return on Invested Capital (ROIC)
• Internal Rate of Return • Excess Returns (based on ROIC)
• Net Present Value • Excess Returns in Dollar or Peso
• Payback Value
• Project Level • Firm Level
 Why Firms Invest: To grow and sustain the firm’s value

Firm Value: Ability to generate and sustain positive cash flow in the
long-term

Keep Costs/ Address Environmental,

Retain & Expand Social and Governance
Customer Base Expenses Down Issues
Core Enhancements: Improve
productivity, cost efficiency, and
effectiveness Market Expansion
Operations & Supply Chain & Logistics Offer existing products or services
Supply of Raw Materials & Immediate Goods to new markets or new customers
HR & Accounting
Customer Service
Sales & Marketing
Technology Services Value Creation
Pathways

New Product Opportunities

Develop new product or service offerings
Long-Range Opportunities
for existing customers
Requires R&D, new manufacturing plant, New Markets + New Products
new suppliers and new internal processes
Why Countries Invest Abroad

• Labor (Skilled + • Size of Population • JV and Partnerships

Unskilled) • Purchasing Power • More common in
• Natural Resources • Consumer or Client advanced countries
(Mining, Agriculture, Preferences
Seafood)
• Export Platform
Resources & Size and Technology &
Location to Key Growth of Country
Customers Market Expertise
Core Enhancement
Core Enhancement – ESG Initiatives
Fairtrade Standards are designed to aid
the sustainable development of some
smaller producers and agricultural
workers in third world countries. In order
to become certified Fairtrade producers,
the cooperatives and their fellow farmers
have to strictly comply with the standards
laid down by Fairtrade International
To be granted and to maintain
certification, companies must receive
a minimum score from an assessment
of "social and environmental
performance", integrate B Corp
commitments to stakeholders into
company governing documents, and
pay an annual fee based on annual
sales.
Market Expansion – Local

In 2019, GARDENIA Bakeries Philippines, Inc. inaugurated

its P2-billion bread manufacturing facility in Mabalacat
City, Pampanga. The new facility can produce 400,000
loaves and buns a day.
Market Expansion - Abroad
New Product Opportunities
Long Range Opportunities –
mRNA Developed as early as 2005 by the University of Pennsylvania and Moderna
 Investment Analysis Process

Internal Rate
of Return
(IRR)
WACC Free Cash
Investment (Weighted Flow Net Present
Cost Average Estimation Value(NPV)
Time Value Cost of
of Money Payback
Capital)
Period
 Balance Sheet: Assets = Liabilities + Equity
Assume you live with your parents, and you have
PhP250,000 in cash deposited in a bank. You want to buy
a house. What will your balance sheet look like before you
enter any transaction?
Cash is an
asset, just like a
house. But
Cash is all you
have

You don’t own

any obligation
to anyone.
 Balance Sheet: Assets = Liabilities + Equity
Now you meet someone selling his beautiful house for PhP1,000,000. You want this house, and you think
the price is good, and decide to buy it.
Since you only have PhP250,000 in cash, you decide to borrow PhP750,000 from a bank.
 Balance Sheet: Assets = Liabilities + Equity

What will your balance sheet look

What will your balance sheet
like once you get the cash from look like once you purchase the
the bank? house?

So you may be living in a PhP1 million house, but your

networth (what you own) is just PhP 250,000.
Note: Net plant and equipment is equal to cumulative
purchases of fixed assets less cumulative depreciation
and cumulative disposed assets.

An accrued liability is an expense that a business has

incurred but has not yet paid such as Christmas
bonuses, SSS, Philhealth.

The main difference between preferred and common

stock is that preferred stock gives no voting rights to
shareholders while common stock does.

Preferred shareholders have priority over a

company's income, meaning they are paid dividends
before common shareholders.

Common stockholders are last in line when it comes

to company assets, which means they will be paid out
after creditors, bondholders, and preferred
shareholders.

Source: Investopedia
Time Value of Money
 Time Value of Money: Definition
Assumptions: 10% Risk-Free Interest Rate from a Bank (“r”)
You don’t have any need for money now or in the near future

Option 1: Option 2: Option 3:

Php 100K Php 109K Php 120K
now

+10 +11
Now: 1 year later: 2 years later:
PhP 100K PhP 110K PhP 121K

Summary: You are better off getting the money now and putting it in a bank. Time
value of money means that it’s not just the amount that matters but when you
receive or give the money away (the “timing”)
 Time Value of Money: Present Value and Future Value
Assumptions: 10% Risk-Free Interest Rate from a Bank (“r”)
You don’t have any need for money now or in the near future

+10 +11
Now: 1 year later: 2 years later:
PhP 100K PhP 110K PhP 121K

Given the assumptions above, what is the present

Given the assumptions above, what is the
future value of PhP 100K in one year?
Answer: PhP 110K
value of PhP 110K one year from now? Or how much
do I need to put in the bank to get PhP 110 in two
years?
Answer: PhP 100K

Given the assumptions above, what is the Given the assumptions above, what is the present
value of PhP 121 in two years? Or how much do I
future value of PhP 100 in Two years?
need to put in the bank to get PhP 121 in two years?

Answer: PhP 121K Answer: PhP 100K

Time Value of Money: Computation of FV
Time Value of Money: Computation of PV
Weighted Average Cost of
Capital (WACC)
 Background on Cost of Capital
• If your business needs to finance a project (a new plant, new
business, new products), there are two ways to do it:
Use the owners' money, known as equity financing, or
Borrow the money from a lender, called debt financing (banks,
bond issuance, capital leasing)
• Both come with costs, and your company's weighted average
cost of capital, or WACC, tells you the combined cost of
your financing.
• WACC attempts to balance out the relative costs of different
sources to produce a single cost of capital figure.
Relationship of Risk and WACC

• The WACC includes payments made on debt obligations

(cost of debt financing), and the required rate of return
demanded by ownership (or cost of equity financing).

• A high weighted average cost of capital, or WACC, is

typically a signal of the higher risk associated with a firm
or an industry's operations. Investors tend to require an
additional return to neutralize the additional risk.
Weighted Average Cost of Capital (WACC)

The capital structure is how

a firm combines debt and
equity used to finance its
overall operations and
growth.
Cost of Equity: Two ways of Computing
Cost of Debt
On a firm level, the cost of debt— 𝑅𝑅𝑅𝑅 – is simply the risk-free country
rate plus the risk premium, which reflects the risk of the firm’s
outstanding bonds.
If a company has a credit rating, the country specific risk-free rate plus
the rating premium is used to calculate the firm’s cost of debt
At the industry level, the cost of debt is the estimated risk-free rate of
the selected country plus a sectorial spread of debt.

If your debt is solely sourced from banks and similar lending

institutions, the cost of debt is the weighted average interest rate your
company pays across all of its loans
Sources of Industry WACCs
• WACC Expert by Finance 3.1
http://www.waccexpert.com/
• New York University Stern School of Business
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/data
current.html
Selected WACC in Emerging Markets: 2018 vs 2021
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datacurrent.html
Upside and Downside of using Industry WACC
• Makes things simple as there exists a single WACC that serves
as a benchmark for each industry and that allows comparison
with internal rate of return (IRR) and return on invested capital
(ROIC)
• Downside would be ignoring firm specific variables
• Effect of zero tax on cost of debt: negligible if weight of debt
is less than 0.5 and/or cost of debt is less than 5%
• Bottomline: There should be a consensus on what WACC to
use for each sector and what adjustments are necessary or
acceptable.
Free Cash Flow (FCF) Estimation
 Accounting Profit versus Free Cash Flow (FCF)
• When evaluating investment, it is Point to remember: We are looking at cash flow related to
the free cash flow that is relevant business operations ONLY and not cash flow related to
and NOT the accounting profit or financing
net income
• ”Free cash” that is free or available Sales  Generates Cash Inflow
for distribution to lenders (banks or
bondholders) or pay dividends to
investors
• You can have high net income, but
low cash when most sales are
booked as accounts receivable Operating Expenses and
Investment  Generates Cash Lenders
• Free cash flow (FCF) represents the Outflow
cash a company generates after take
taking account of “cash outflows to priority
support business operations and over
maintain its capital assets.” owners
• FCF can reveal problems in the Free Cash Flow is the cash that will
fundamentals before they arise on
be left to distribute to lenders +
the income statement
owners (residual)
How to Compute Free Cash Flow (FCF)
Free cash flow is a measure of profitability that excludes depreciation expense
(non-cash items) and includes spending on investments (equipment and assets
as well as changes in working capital from the balance sheet)

𝐹𝐹𝐹𝐹𝐹𝐹 = 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 ∗ 1 − 𝑡𝑡 + 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 – 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 – 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑖𝑖𝑖𝑖 𝑁𝑁𝑁𝑁𝑁𝑁 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶

FCF= Free Cash Flow

EBIT= Earnings before interest payments and tax payments

t = taxes
Depreciation Expense from Income Statement

Capex = Capital Expenditures (machines, buildings, technology, R&D)

Working Capital = Funds used for day-to-day operations; usually a function of sales
Overview of Investment Decision
Tools:
Internal Rate of Return (IRR)
Net Present Value (NPV)
Payback Period
A firm’s ability to stay competitive and survive depends
on constant flow of projects (big or small).

Hence, it is imperative for a firm to evaluate projects as

accurate as possible and for decision-makers (CEO, CFO)
to use their business judgment.

Investing in the wrong projects wastes time, energy, money,

and entails opportunity costs
 Investment Analysis Process

Internal Rate
of Return
(IRR)
WACC Free Cash
Investment (Weighted Flow Net Present
Cost Average Estimation Value(NPV)
Time Value Cost of
of Money Payback
Capital)
Period
Definition: Net Present Value
• Net present value (NPV) is the sum of the present value of
cash inflows and the present value of cash outflows over a
period of time.
• NPV is used investment planning to analyze the viability of a
projected investment or project.

Decision Criteria: NPV>0 and choose the project that has a higher
NPV
Project Cupcake: PhP 10,000 Initial Investment
What is Project Cupcake’s NPV? Long Way

5,300/(1 + 𝑟𝑟)
2
4,300/ 1 + 𝑟𝑟
3
1,874/ 1 + 𝑟𝑟
4
1,500/ 1 + 𝑟𝑟
What is Project Cupcake’s NPV? Short-Cut
Internal Rate of Return: Definition
The internal rate of return is defined as the rate that
equates the present value of a project's cash inflows to its
outflows. In other words, the internal rate of return is the
interest rate that forces NPV to zero.

The calculation for IRR can be tedious, but Excel provides

an IRR function that merely requires you to access the
function and enter the array of cash flows.

If IRR > WACC, the project’s rate of return is greater than its
costs.
Solve for R and compare to see it with r :

5,300 4,300 1,874 1,500

0 = −10,000 +
(1+𝑅𝑅)
+ (1+𝑅𝑅)2 +
(1+𝑅𝑅)3
+
(1+𝑅𝑅)4
What is Project Cupcake’s IRR?
Payback Period
• The payback period is defined as the expected number of
years required to recover the investment
• Served as the first formal method used to evaluate capital
budgeting projects.
• Two major flaws:
• Doesn’t discount the cash flow - but can be addressed
• Failure to consider beyond-payback cash flows is a problem for both
payback methods.
Payback – based on cash flow (no discounting)
Payback – based on discounted cash flow
Let’s recap what we discussed
yesterday
 Investment Analysis Process

Internal Rate
of Return
(IRR)
WACC Free Cash
Investment (Weighted Flow Net Present
Cost Average Estimation Value(NPV)
Time Value Cost of
of Money Payback
Capital)
Period
WACC has many names, but it is simply the minimum rate of
return that a business must earn before generating value.

Weighted Average Cost of Capital

(WACC)

Discount Rate Hurdle Rate Cost of Capital

Components of WACC, Discount Rate, Hurdle
Rate
Weight of
Equity

Cost of Equity
WACC
Weight of Debt

Cost of Debt &

Tax Rate
Investment Analysis Tools

Tool Decision Criteria

Net Present Value (NPV) If NPV >0

Internal Rate of Return (IRR) If IRR>WACC

Payback Period Depends on nature of project

 Why do we need to discount cash flows using WACC
for NPV?
Answer:

So we can compare the present value of initial investment with

the present value of cash inflows resulting from the project or
investment over a period of time.

Present Value of
Investment Cost
₱10,000

Present Value of Cash

Inflows from Year 1 to
Year 4
₱10,804.38
Remember about the importance of timing of
cash flows:

The sooner we get the positive cash

flow, the higher the IRR, the higher the
NPV, and the less time it is required to
recoup investment
Let’s go back to Project Cupcake – NPV is higher,
when we get cash flows sooner than later
Project Cupcake IRR
Now, it’s time to put them all
together
How to Compute Free Cash Flow (FCF)
Free cash flow is a measure of profitability that excludes depreciation expense
(non-cash items) and includes spending on investments (equipment and assets
as well as changes in net working capital from the balance sheet)

𝐹𝐹𝐹𝐹𝐹𝐹 = 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 ∗ 1 − 𝑡𝑡 + 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 – 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 – 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑖𝑖𝑖𝑖 𝑁𝑁𝑁𝑁𝑁𝑁 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶

FCF= Free Cash Flow

EBIT= Earnings before interest payments and taxes

t = taxes
Depreciation Expense from Income Statement

Capex = Capital Expenditures (machines, buildings, technology, R&D)

Working Capital = Funds used for day-to-day operations; usually a function of sales
Total Investment = Capital Expenditures + Change in Net Working Capital

Definition of Capital Expenditures

• Purchase of Land
• Purchase of Building
• Construction of Plant or Building
• Long-Term Equipment
• Research & Development (R&D)
• Investment in Technology (Hardware + Software)
Total Investment = Capital Expenditures + Change in Net Working Capital

First Step: Estimate Net Working Capital

• Net Working Capital = Current Assets – Current Liabilities
• Net Working Capital = Accounts (Trade) Receivables – Accounts (Trade) Payable
• Net Working Capital = Increase in Sales based on a Growth Rate

Second Step: Take the Difference between Current Period and Last
Period
Change in Net Working Capital = Net Working Capital (Year 2) – Net Working Capital (Year 1)

Note: If the change is positive, it’s a cash outflow; if it’s negative, it’s a cash inflow. The reason is that if
it’s positive, the company needs extra funding to keep the business running. It can also mean business
is expanding
Key Reminders

• You are looking at the firm’s operating cash flow only

• Don’t include cash flows related to financing be it a bank or an equity
investor (such as advancement of a loan, interest expenses, equity
infusion)
• Add back “non-cash” items taken out of net income such as
depreciation expense
• Deduct capital expenditures and changes in net working
capital requirements
• Decide on an appropriate WACC
• Industry benchmark is convenient and excellent for benchmarking
purposes
Before we proceed to the case study, let’s have a
quick review:
• Question 1: Most financial decisions involve situations in
which a payment is made at one point in time and receives
money later. Money given out or received at two different
points in time is different. This ”difference” can be dealt with
using:
a) Time Value of Money analysis (PV /FV)
b) Inflation
c) Systemic Risk of a Stock
d) Depreciation
Review: Continuation

• Question 2: Discounting is the process of finding the present

value of future cash flows
a) True
b) False

• Question 3: The weighted average cost of capital is based on

company’s cost of debt only
a) True
b) False
Review: Continuation

• Question 4: When estimating the WACC, always use 50%

equity and 50% debt as weights
a) True
b) False
Review: Continuation
• Question 5: Investment decisions are the least important
decisions business leaders make
a) True
b) False

• Question 6: A more appropriate way to analyze

attractiveness of potential projects is through
a) Return on Investment (Dividing profit of an investment is by the cost of the
investment)
b) Interest Rate
c) Break-even Method
d) IRR and NPV
Review: Continuation
• Question 7: When evaluating investments, we should look at
the profit from the project or investment
a) True
b) False

• Question 8: What is an example of a non-cash item

that you need to add back to your Net operating profit
after tax (NOPAT) to compute the FCF?
a) Depreciation Expense
b) Labor Expense
c) Training Expense
Case Study: Energy Project
Applications
Assessing redundancy of tax
incentives
Definition
• When are tax incentives necessary?
• Answer: Investments that would not have been made without tax
incentives
• When do tax incentives become redundant?
• Answer: Investments that would have been made even without tax
incentives.
• When awarding the incentives to a firm that would have invested
even without tax incentives, it is not the most productive use of
government resources
 Nuisances and Challenges

Economic Benefits
Government Priority
(employment, income,
technology transfer)
Projects that Projects that
lead to huge Investment Priority List are flawed
Impact on Poverty,
wealth for Environment, Long-Term R&D and lead to
firms Capabilities, Human Capital losses
Development Pioneer Activity
Bottomline:
Decisions are Country,
Political,
based on non-tax and
factors Economic
Risk

Attractiveness of
the Project or
Access to
Finance Firm’s Opportunity (as
Measured by IRR,

Investment NPV, Payback d

Related Metrics)

Decisions

Corporate
Organizational Strategy
Capabilities
Process for Assessing Potential Redundancy

1. Have two scenarios:

• Free cash flow without tax incentives and other perks
• Free cash flow with tax incentives, other perks such as 5% of gross
income, enhanced deductions
2. Compare IRR, NPV and Payback for each of these two
scenarios and see whether incentives do make a huge
impact on the decision criteria of the application
Case Study on Redundancy
The two firms decide to apply for tax incentives
 Assessing Potential Redundancy

The IRR of Biomass Project is a borderline case. The tax

incentives would make a huge difference in the attractiveness of
the project.
 Summary and Key Take-aways
• Evaluating projects using IRR, NPV and payback puts you in the shoes of the
business decision-maker
• Given the limited resources, we want to avoid deploying incentives in the most
unproductive way possible and aim to channel them where they are most
needed and have the most positive impact
 Thus, it is important to evaluate the IRR, NPV and Payback of projects based on two
scenarios:
• With Incentives
• Without Incentives
• When assessing applications, it’s important to run your investment analysis, but
equally just as important are knowing:
 The industry and market analysis to understand factors that will affect the project outcome
 The firm’s organizational capabilities and senior management as these determine project
outcome
 What makes tax incentives redundant