Financing Analysis

From Virbus

[edit] 1 FINANCING ANALYSIS

[edit] 1.1 The cost of capital

The cost of capital for a firm is a weighted sum of the cost of equity and the cost of debt. WACC (Weighted Average Cost of Capital) is the average of the costs of these sources of financing (debt and equity), each of which is weighted by its respective use in the given situation:

The cost of debt (loan) depends on many factors, but it is actually given to the entrepreneurs by a bank. So, they do not have to calculate it.

The cost of equity () is really tricky to calculate. The most common way is to use CAPM:

Risk free rate of return is the interest rate of government long-term bonds. Rm-Rf is a market risk premium and can be found on the pages of different financial consultants (e.g. Damordaran). Beta coefficient can be calculated as follows:

You have to bear in mind that debt is always cheaper than equity!

[edit] 1.2 EBIT-EPS analysis and capital structure

The EBIT-EPS approach is a method of structuring the firm's capital structure by determining the combination of funding sources that maximizes earnings per share (EPS) over the firm's expected range of earnings before interest and taxes (EBIT). We can examine the effects of various financing alternatives through an EBIT-EPS analysis, which involves determining the point of indifference EBIT at which the EPS is the same between two financing alternatives (only equity financing or mixed debt and equity financing).

EBIT-EPS graphical analysis involves graphing EPS as a function of EBIT for each leverage level. EBIT-EPS analysis can be presented graphically as follows:

It is important to determine the point of indifference, which occurs when the two plans offer the same EBIT. Mixed financing should be preferred to the right of the point of indifference because of the higher EPS.

[edit] 1.3 Loan amortization schedule

An amortization schedule is a table detailing each periodic payment on an amortizing loan. Many kinds of amortization exist, but the annuity method is most often used in practice.

L – amount of loan, PMT – annuity payment, i – interest rate, I – interest.

If interest rates are fixed, the annuity payment will be the same every year. The principal portion increases every year whereas the portion paying interest decreases.

[edit] 2 INVESTMENT ANALYSIS

[edit] 2.1 Cash-flows

Cash flow removes all of the accrual accounting adjustments that appear on an income statement, such as depreciation, and allows us to see a company's earning power and operating success in a slightly different way. Operating and free cash flows need to be calculated in order to conduct performance analysis.

Operating cash flow (OCF) is the amount of cash that a company has left over after it has paid all its operating cash expenses: , S – sales, VC – variable costs, FC – fixed costs, D – amortization.

CF (Cash Flow) is the amount of cash that a company has left over after it has paid all of its expenses, including investments in fixed assets and net working capital:

INV – investment in fixed assets, – investment in net working capital.

Initial investment (outflow):

.

[edit] 2.2 Performance indicators

There are many different performance indicators in financial theory, but net present value and internal rate of return are most often used in capital budgeting.

NPV (Net Present Value) is the difference between the present value of cash inflows and the present value of cash outflows:

,

WACC – the weighted average cost of capital, IO – initial investment.

Project preliminary evaluation criteria: , accept the project. , additional analysis is needed. , reject the project.

Profitability Index (PI) enables one to identify the relationship of investment to payoff of a proposed project:

, accept the project. , additional analysis is needed. , reject the project.

IRR (Internal Rate of Return) is the discount rate that makes the net present value of all cash flows from a particular project equal to zero. It is a compounded return rate which can be earned on the invested capital, i.e. the yield on the investment:

.

IRR must be higher than the weighted average cost of capital (WACC).

The MIRR is similar to the IRR, but is theoretically superior in that it overcomes two weaknesses of the IRR. The MIRR correctly assumes reinvestment at the project’s cost of capital and avoids the problem of multiple IRRs. However, the MIRR is not used as widely as the IRR in practice.

,

– investments in period t, k – reinvestment rate of return. 

Discounted payback (PB) period is the period of time required for the return on an investment to repay the sum of the original investment:

,

– year before full recovery,  – uncovered discounted cash flow at start of year,  – discounted cash flow during the year.

[edit] 3 Advanced break-even analysis

The accounting (operating) break-even point is defined as that level of sales (either units or euros) at which EBIT is equal to zero. Accounting break-even in units:

Accounting break-even (in euros):

The cash (flow) break-even point is defined as that level of sales (either units or euros) at which EBITDA (earnings before interest, taxes, depreciation and amortization) is equal to zero. Cash break-even in units:

Cash-flow break-even (in sales):

The financial break-even point is defined as that level of sales (either units or euros) at which NPV is equal to zero. Financial break-even in units:

,

Financial break-even (in sales):

Although accounting (operating) break-even is most widely used in practice, the financial break-even measures the “true” break-even point of projects that investors need to earn a return on their investment.

[edit] 4 SENSITIVITY ANALYSIS

[edit] 4.1 Leverage analysis

DOL (Degree of Operating Leverage) is a quantitative measure of the “sensitivity” of a firm’s operating profit to a change in the firm’s sales. The closer that a firm operates to its break-even point, the higher is the absolute value of its DOL. When comparing firms, the firm with the highest DOL is the firm that will be most “sensitive” to a change in sales. The DOL percentage in change in a firm’s EBIT resulting form a 1 percent change in quantity (sales):

DFL (Degree of Financial Leverage) is a quantitative measure of the “sensitivity” of a firm’s earnings per share (EPS) to a change in the firm’s operating profit (EBIT). The higher the degree of financial leverage, the more volatile EPS will be, all other things remaining the same. The DFL percentage change in a firm’s EPS resulting from a 1 percent change in operating profit (EBIT):

DTL (Degree of Total Leverage) is a quantitative measure of the “sensitivity” of a firm’s earnings per share (EPS) to a change in the firm’s sales. The DTL percentage change in a firm’s earnings per share (EPS) resulting from a 1 percent change in output (sales):

[edit] 4.2 NPV sensitivity analysis

Sensitivity analysis enables one to know how much a given assumption affects your result. In other words, you want to determine the sensitivity of the forecast to each assumption. The sensitivity chart gives you the ability to quickly and easily judge the influence each assumption cell has on a particular forecast. In capital budgeting, the NPV is the most important performance indicator. Therefore, it is extremely important to judge the influence their arguments (key inputs) have on its value. The most important arguments are (in restaurant business): Weighted average cost of capital (WACC) Occupancy level Labor costs