CASE STUDY 1
An investor, who is used to making investments as long as he obtains a minimum return of 20% per year, is offered for sale a business that is in operation dedicated to the manufacture of executive chairs.
financial-evaluation-of-projects-7-practical-cases-for-companiesA valuation study of the business contracted by the current owner, defined its value at $ 70,000,000. The investor decides to carry out a financial evaluation based on the historical information provided by the owner, to make the decision to buy or not the business.
HISTORICAL DATA ON SALES
The current production costs per unit, using the variable costing system, are discriminated as follows:
For each unit sold, a profit of 80% is obtained on the total unit cost (when the variable cost system is used, the total unit cost is equal to the variable unit cost). Production equipment is worth $ 50,000,000 with a 10-year useful life, depreciates in a straight line and has already been depreciated by $ 15,000,000. Office equipment is already depreciated and therefore its book value is zero and it is not expected to sell it for any value. Operational expenses are $ 1,800,000 annually. A 3.0% increase in all expenses and costs is expected, which corresponds to the estimated average annual inflation for the next 5 years. The surrender value is equal to the book value of the fixed assets at the end of the evaluation horizon that is defined in 5 years,without taking into account the recovery of working capital. If the tax rate is 35%, what decision should the investor make?
SOLUTION
First of all, it is necessary to make sales projections for the next 5 years, which corresponds to the project evaluation horizon. The simplest way to do them is to lean on the Excel spreadsheet and applying the fit line method to a scatter plot developed in Chapter 3, Example 3.2, the fit line equation is designed.
The structure of table 1 is built in the Excel spreadsheet.
Table 1
1. We mark the range B2: C9
2. We click Insert
3. We click Dispersion
4. We double-click on the type of graph 3 and Excel draws the scatter plot
5. We click on any point of the graph and with the right button we click again on adding trend line
6. In options of trend lines we click on Linear, click on present equation on the graph and on presenting the value of R2 in the graph and we clicked accept
7. Excel designs the linear adjustment equation, which for this case is: Y = 4.7738 X + 180.39, where Y = sales and X = the number of periods. Excel also calculates R2 which corresponds to the coefficient of variation. To know how well the variables are correlated, we calculate the correlation coefficient (R), known R2, and obtain a value of 0.9544, greater than 0.95, therefore, the adjustment equation is valid to make the projections. In case of finding an R value less than 0.95, it is necessary to look for other trend curves.
To make sales projections from 2012 to 2016 we apply the equation Y = 4.7738X + 180.39, where Y corresponds to the number of chairs expected to be sold each year and X corresponds to the number of periods. The projected sales for each year (formatted the cell so that it appears without decimals, because the number of chairs cannot have a fraction) multiplied by the unit sale price (PVU) and by the total unit cost (CUT), will give us as a result the value of income and production costs respectively for each evaluation year.
* The values are rounded to avoid working with decimals and the small differences in the results are due to the fact that in this table the arithmetic operations were done with a calculator and in the project cash flow the calculations were made with Excel.
Initial investment calculation
The initial investment for the potential buyer of the business is $ 70,000,000.
Depreciation calculation
When depreciating production equipment using the straight-line method, the annual depreciation charge is $ 5,000,000 resulting from dividing $ 50,000,000 (historical value of equipment) between 10 years of useful life. The accumulated depreciation of $ 15,000,000 means that of the $ 50,000,000, $ 15,000,000 has already been depreciated and that the teams have already provided services for 3 years. Office equipment for being totally depreciated has no book value, so its book value is zero.
Despite making projections of income and expenses at current prices, the annual depreciation charge escapes from this consideration because in our tax legislation there are no inflation adjustments and the Treasury only accepts to deduct as an accounting expense the depreciation value calculated on historical value.
Redemption value calculation
The salvage value of the project is $ 10,000,000 corresponding to the book value of the fixed assets. At the time of offering the business and the production equipment for sale, they were depreciated by $ 15,000,000 which added to the $ 25,000,000 per depreciation charge during the 5 years of the evaluation period would result in a value of $ 40,000,000., corresponding to 8 years of depreciation. Given a useful life of 10 years, 2 years would be pending for the equipment to be totally depreciated.
VR = Historical value - Accumulated depreciation
VR = $ 50,000,000 - $ 40,000,000 = $ 10,000,000
When using the accounting method (or asset method) to calculate the salvage value of a project, working capital should be considered as any other asset that is recovered at the end of the project evaluation horizon. In the formulation of this exercise we have assumed that there is no recovery of working capital, therefore, we will not take this income into account.
Calculation of operating expenses
The current operating expenses are $ 1,800,000 and as an annual increase equivalent to the projected inflation of 3.0% for the next 5 years is estimated, the inflationary effect is applied for each year.
* It works with rounded values, especially when it comes to projected values
CASH FLOW OF THE PROJECT
CURRENT PRICES
With a discount rate of 20% per year (investor opportunity rate), a NPV of $ - 3,843,860 is obtained and an IRR of 17.42%, lower than the investor opportunity rate, therefore, the investment must be rejected because it does not meet the investor's expectations of profitability.
CASE STUDY 2
The investor of case study 1, for strategic reasons, is interested in buying the business and knows that a determining factor in the decision to accept or reject a project is the cost of the investment. You are not willing to lower your expectations of return on your contributions, but you have the possibility to get a bank loan worth $ 35,000,000 with a term of 5 years at an interest rate of 12% effective per year, payable with 5 equal annual fees. Calculate:
a) Business profitability
b) Investor profitability
c) Project profitability with financing
d) Project payment capacity
SOLUTION
a) The profitability of the business, measured by the IRR, continues to be 17.42% per year compared to the opportunity rate of the investor of 20% per year indicates that the project should not be undertaken because its profitability is less than the cost of the investment. The IRR is a characteristic of an investment project, which does not depend on the way the initial investment is financed, that is, the IRR does not take into account the effect of financial leverage.
b) To calculate the investor's profitability, it is necessary to build his cash flow, for which the effect of the financing is included in the cash flow of the project and the initial investment is reduced to the value of his contributions.
Calculation of the bank loan installment
In order to know the tax impact of the debt, it must be distinguished which part of the installment paid to the entity that granted the loan is interest and which part is a capital payment, because the interest is deductible in a 100% as expenses for the period and are recorded in the investor's cash flow as a deductible expense, while amortization or capital payment is recorded as a non-deductible expense, since it does not constitute cost but rather a return of the loan.
INVESTOR CASH FLOW
CURRENT PRICES
Apparently the IRR of the project increased from 17.42% per year (see case study 1) to 26.17% per year due to the effect of financial leverage, but it is dangerous to confuse the total profitability of the project which is 17.42% per year with the profitability of the investor who it is 26.17% annually. The financial evaluation of this business (see case study 1) shows that the profitability of the project is not attractive (project IRR of 17.42% per year lower than the investor's opportunity rate of 20% per year), but the profitability of the own resources if it is (IRR of the investor of 26.17% greater than the opportunity rate of the investor of 20% per year)
c) In order to analyze the profitability of the project with financing, it is necessary to calculate the cost of capital, since the initial investment will be financed with two sources of financing with different costs.
The after-tax cost of the credit is:
The capital cost is 13.90% per year, which represents the cost of the investment (discount rate) and constitutes the minimum profitability required of the investment project.
The structure of the cash flow without financing (or pure project) and with financing is the same. There is a difference in the treatment that is given to each of them when calculating the NPV because the cost of the investment (discount rate) is different and the NPV is dependent on this rate. When the investment is covered with own resources, the discount rate is the investor's opportunity rate, while if it is financed from different sources with different costs, as in the present case, the discount rate is the weighted average cost or capital cost.
CASH FLOW OF THE PROJECT WITH FINANCING
CURRENT PRICES
With a discount rate of 13.90% per year (cost of capital), a NPV of $ 5,865,916 is obtained. The IRR continues to be 17.42% per year, because as it is a characteristic of the project, its value does not change due to the effect of financial leverage, that is, the total profitability of the project, measured by the IRR, is indifferent to the form how the initial investment is financed. What does change is the decision to accept or reject a project when the cost of the investment changes. In this case, since the IRR of 17.42% per year is greater than the investment cost (capital cost) of 13.90% per year, the project must be accepted. The VPN is equal to $ 5,865,916, greater than zero, therefore the project must be accepted.
Financing (Serrano, 2010) can make investment in projects that are not, by themselves, attractive, or what is the same, good financing can improve a bad investment. This project is not profitable per se, but the investor makes it profitable for itself through financial leverage.
In general, cheap sources of financing should not be used to justify and implement projects that do not have adequate profitability on their own.
D) With the calculations made up to now we have been able to reach two important conclusions:
1. The project itself is not profitable
2. External financing, due to the effect of financial leverage, makes a bad project profitable for the investor, that is, good financing can improve a bad investment. We observe this to analyze the results of the financial evaluation of the project with financing, which gave us a NPV value of $ 938,846 and without financing a NPV of $ -3,843,860, which indicates that this project without financing is not profitable and with financing if it is.
Now it is time to build a cash budget to verify the payment capacity of the project.
CASH BUDGET
* The minimum cash (see row 22) is an arbitrarily assumed value and corresponds to what companies must have permanently in cash for operational purposes, security buffer and speculative effects.
According to the results obtained in the CASH AVAILABLE row (see row 23), we observe that the project generates enough cash to meet the debt commitment. Due to the effect of financial leverage, this bad project in itself now shows to be profitable.
CASE STUDY 3
An investor is studying the advisability of building a plant to manufacture disposable diapers with an initial investment of $ 80,000,000, of which $ 20,000,000 corresponds to the value of the land, $ 40,000,000 to the value of the plant, $ 8,000,000 to working capital and $ 12,000,000 to preoperative expenses (licenses, permits, incorporation expenses, commissions and, in general, all expenses incurred before the project comes into operation). The plant has a useful life of 10 years and depreciates in a straight line. According to the market study, for which the investor paid $ 15,000,000, it is estimated that the sales volume will be 100,000 units during the first year with an increase of 4% per year. The increase in sales does not require an expansion of the plant.The unit sale price is $ 890 and the total unit cost is $ 650, values that undergo an increase each year equal to inflation estimated at 4% per year for the next 5 years. It is anticipated that the plant can be sold at the end of year 5 for $ 22,000,000, that initial working capital is recovered 100%, and that additional investments in working capital are not recovered. Operating expenses are estimated at $ 3,000,000 with an annual increase of 3% and the tax rate is 35%. With a 5-year evaluation horizon, calculate:that the initial working capital is recovered by 100% and that the additional investments in working capital are not recovered. Operating expenses are estimated at $ 3,000,000 with an annual increase of 3% and the tax rate is 35%. With a 5-year evaluation horizon, calculate:that the initial working capital is recovered by 100% and that the additional investments in working capital are not recovered. Operating expenses are estimated at $ 3,000,000 with an annual increase of 3% and the tax rate is 35%. With a 5-year evaluation horizon, calculate:
a) Profitability of the project itself with an annual effective investor opportunity rate of 15%.
b) Profitability of the project if the land is owned by the investor, which could be leased for 5 years with a single payment in the first year for $ 10,000,000
c) Profitability of the investor if the working capital is financed with a credit to 3 years at a rate of 18% annual cash with the payment of equal annual fees.
SOLUTION
a) To calculate the profitability of the project itself, that is, considering that all the initial investment is covered with investor resources, it is necessary to calculate the net cash flows that, when compared with the initial investment, result in the NPV and the IRR, using the investor's opportunity rate as the discount rate.
Calculation of the initial investment.
A controversy arises in the sense of considering the preoperative expenses as a dead cost for the project and, therefore, they should not be considered as an initial investment. In our opinion, and if by definition a dead cost is a cost incurred in the past, unrecoverable even if you decide not to invest in the investment project, preoperative expenses are incurred only if the decision is made to invest in the project and, therefore, Therefore, they are relevant expenses that should be considered as an initial investment and are recovered through the amortization tax mechanism.
Calculation of depreciation of fixed assets and amortization of deferred assets
The plant depreciates in a straight line with a useful life of 10 years
Depreciation and amortization have the same financial connotation, so much so that in the Income Statement they appear on the same line. The investment in fixed assets is recovered through depreciation and the investment in deferred assets is recovered through amortization.
The cost of the market study is a dead or irrelevant cost, therefore, it is not recorded as an initial investment, but it must consider the annual amount of its amortization in the cash flow of the project, since the tax benefit is only received if the project is carried out.
Total annual charge for depreciation and amortization = $ 6,700,000
Income from product sales and production costs
• We work with rounded values, especially those that are projected values
Investment in working capital.
The increase given in working capital due to the inflationary effect must be financed with the cash flow generated by the project. You only have to make additional investments in this item when there is a real increase in sales and / or production, as in this case in which it is estimated that sales will increase by 4% per year.
INVESTMENT IN WORKING CAPITAL
The investment in working capital for each evaluation year is recorded in the project's cash flow as non-deductible expenditure.
Redemption value calculation. The surrender value is the book value of fixed assets and deferred assets plus the recovery in working capital.
Plant book value = historical cost - accumulated depreciation
Plant book value = $ 40,000,000 - $ 20,000,000 = $ 20,000,000 book
value preoperative expenses = historical cost - accumulated depreciation
book value preoperative expenses = $ 12,000,000 - $ 6,000,000 Book
value preoperative expenses = $ 6,000,000
The plant is expected to be sold at the end of year 5 for $ 22,000,000, a value higher than its book value, therefore, there is an occasional profit of $ 2,000.000 that generates a tax payment.
For what is expressed in the previous item, the recovery value of working capital is affected by the inflationary effect in nominal form, not in real form, if there is no real increase in sales when making projections at current prices. Suppose that the initial investment in working capital in period zero is $ 1.0 and that there is no real increase in sales. Due to the increase in prices, due to the inflationary effect, to maintain the same investment in working capital, more resources are required each period, so that if inflation is 1.0% per year, prices increase by this percentage and the capital of work at the end of year 5 equals $ 1.05
Working capital = $ 1.0 (1 + 0.01) 5 = $ 1.05
This indicates that if the working capital invested in period zero is $ 1 and if at the end of year 5 it is recovered 100%, $ 1.05 will be received. This nominal increase in working capital is covered in its entirety by the cash flows released by the project, because although it is true that every day it is necessary to take out more money to maintain the same working capital, also every day a higher income from sales of the good or service.
In the cash flow of the project, the book value of the plant, the book value of the pre-operating expenses and the working capital (affected by inflation) are recorded as non-taxable income. The statement of the exercise establishes that the additional investments that are made each year in working capital are not recovered, therefore, they are not taken into account in this calculation. The occasional gain is recorded as taxable income.
Recovery of working capital = $ 8,000,000 (1 + 0.04) 5 = $ 9,733,223
Total value of non-taxable income = Book value of plant + Book value of pre-operating expenses + Recovery of working capital
Total value of non-taxable income = $ 20,000,000 + $ 6,000,000 + $ 9,733,223
Total value of non-taxable income = $ 35,733,223
CASH FLOW OF THE PROJECT
CURRENT PRICES
With a discount rate of 15% per year, the NPV is equal to $ 3,586,316, greater than zero, and the IRR is 16.64% per year greater than the discount rate, therefore, the project must be accepted.
b) To calculate the profitability of the project assuming that the land is owned by the investor, in the cash flow of the project, in period zero, the value of the land is discounted, leaving an initial investment of $ 60,000,000 and recorded the value of the single lease for $ 10,000,000 in year 1 as opportunity cost.
CASH FLOW FROM THE PROJECT
CURRENT PRICES
The NPV increased to $ 14,890,664 and the IRR to 23.01% annually, so the project continues to be profitable.
c) Before constructing the investor's cash flow, it is required to analyze the behavior of bank credit. INVESTOR CASH FLOW
CREDIT AMORTIZATION TABLE CURRENT PRICES For the investor, the project is profitable because the return on its contributions of 16.91% per year is greater than its opportunity rate of 15% per year. In summary, this project is profitable without financing and with financing. CASE STUDY 4
A farmer is analyzing the possibility of cultivating cotton on 100 hectares of land he owns, currently valued at $ 500 million pesos, which he could lease for $ 20,000 Hectare / month if he decides not to cultivate it. The investment in machinery and equipment needed to develop the tillage, maintenance and harvesting process amounts to $ 150,000,000 with a useful life of 10 years, depreciable in a straight line. Cotton cultivation lasts for 5 months from the moment the tillage of the land begins, until the harvesting process ends and the product is sold. The expenses are detailed below:
1. Expenses in fuel, lubricants and labor in the process of land preparation, sowing, maintenance and collection for $ 18,000 / hectare / month
2. Purchase of seed for sowing at a rate of 25 Kgs / hectare, at $ 1,500 / Kgs
3. Two aerial fumigations are required throughout the project cycle, one in month 2 and the other in month 4, each worth $ 2,500,000.
4. Transportation costs that will occur during the last month, from the cultivation site to the plant is estimated at $ 18,000 / ton
5. Production is expected to be 2 tons per hectare at $ 950,000 / ton
6. Product sales revenue is received at the end of year 5
7. It is estimated that the machinery and equipment can be sold at the end of the harvest for a value equivalent to 90% of the purchase price
8. The tax rate is 35%
Calculate:
a) Crop profitability with an opportunity rate of farmer 16% effective per year
b) What must be the minimum production level, in tons / hectare, for the crop to be profitable for the farmer?
SOLUTION
Traditionally, for practicality and simplicity, to evaluate investment projects, the project's cash flow is constructed for annual periods and income and expenses are recorded at the end of each annual period, when we know that in reality they flow throughout the year. In general terms, the period to record income and expenses depends on the characteristics of each project. Due to the above and given the characteristics of this project, we will take monthly periods to build the project's cash flow and monthly expenses and income will be recorded at the end of the project evaluation horizon.
Calculation of working capital.
The investment in working capital is represented by the resources required to cover the expenses in fuels, lubricants, labor, purchase of seed, expenses in fumigations and transportation expenses.
a) The monthly expense in fuel, lubricants and labor is:
$ 18,000 hectare / month X 100 hectares = $ 1,800,000 / month
b) The investment in the purchase of seed is $ 3,750,000
c) The value of the two fumigations is $ 5,000,000
d) Transportation expenses at the end of month 5 is $ 3,600,000
Investment in working capital = $ 1,800,000 X 5 months + $ 3,750,000 + $ 5,000,000 + $ 3,600,000 = $ 21,350,000
Calculation of initial investment
Calculation of depreciation of fixed assets
The annual depreciation charge is $ 15,000,000 resulting from dividing the historical value of machinery and equipment by its useful life.
The lands are fixed assets that are not depreciated, therefore, in addition to being a dead cost, this project does not receive the tax benefit of depreciation.
Redemption value calculation
Machinery and equipment are expected to be sold at the end of year 5 for a value equivalent to 85% of the acquisition
value. Sale value = 0.90 X $ 150,000,000 = $ 135,000,000 Book
value = Historical value - Accumulated depreciation Book
value = $ 150,000,000 - 15,000,000 = $ 135,000,000
When comparing the expected sale value with the book value, it is observed that there is neither loss nor profit from the sale of the fixed assets, therefore, the sale value (equivalent to its book value) is recorded in its all as nontaxable income.
The investment in working capital is irrecoverable because, despite being considered as an asset, all the investment in this item is represented in cash in period zero destined to cover current expenses such as fuels, lubricants, labor, etc.
Opportunity cost calculation
The 100 hectares of farmer-owned land currently valued at $ 500 million pesos is a dead cost and therefore should not be included as an initial investment. However, by using the land for planting cotton, the farmer incurs an opportunity cost represented in the benefit he would receive if he decided, for example, to lease the land at $ 20,000 / hectare / month instead of using it.
Opportunity cost = $ 20,000 X 100 hectares = $ 2,000,000 per month
Opportunity cost = $ 2,000,000 X 5 months = $ 10,000,000
Discount rate calculation
The farmer's opportunity rate is 16% effective per year, but since the evaluation periods are monthly, the opportunity rate must be expressed as the effective monthly rate.
Sales
income There is a single income in month 5 for the sale of cotton
2 tons / hectare X 100 hectares X $ 950,000 / ton = $ 190,000,000
Taxes
The useful life of the project is less than a fiscal period (1 year) in such a way that the monthly expenses (labor, lubricants, fuels), value of fumigations, depreciation, taxes, etc., by practicality are accounted for at the end of month 5, which corresponds to the end of the project evaluation horizon. However, for illustrative purposes these expenses are recorded in the cash flow at the time they occur but are not taken into account for the calculation of the monthly net cash flows. The payment of taxes is reflected in month 6, but it will actually be made at the beginning of the following year according to the tax calendar.
CASH FLOW OF THE PROJECT
CURRENT PRICES
The NPV is positive and the IRR is greater than the investor's opportunity rate, therefore, the cotton cultivation project is profitable
b) To calculate the minimum production level in tons for the project to be profitable, the NPV must be equal to zero. Considering that the cash flow was built in the Excel spreadsheet, we follow the following procedure:
1. We are located in cell B25 (cell in which the VPN value appears)
2. In the toolbar we click in DATA
3. We click Analysis And if
4. Click Search Objective
5. In Define the cell should appear B25
6. In With the value we write zero
7. In To change the cell we click on G11 and we give ENTER and we obtain a value of $ 119,508,716 which divided by $ 950,000, which is the value of the ton, we obtain 125.80 tons. If we want to know the yield in tons per hectare, we divide this value by 100, which is the number of hectares, and we obtain 1.2580 tons per hectare. Rounding off values we can say that for the cotton planting project given these projections to be profitable, production must be 1.30 tons per hectare.
CASE STUDY 5
An investment project requires the following investments in period zero: $ 80,000,000 in depreciable fixed assets, $ 20,000,000 in working capital and $ 10,000,000 in pre-operating expenses. Fixed assets depreciate in a straight line with a useful life of 10 years. According to market projections, in the first year 200,000 units will be sold and sales will increase annually with average inflation estimated at 4% per year. The unit sale price is $ 1,150 and the total unit cost is $ 920, values affected by inflation. Operating expenses are estimated at 5.0% of the value of sales. The project is expected to have a long useful life, therefore the economic method with an evaluation horizon of 5 years will be used to calculate the salvage value.
The project is of interest to two investors A and B, whose opportunity rates are 15% per year and 18% per year respectively, with individual contributions of 50% of the initial investment. If the tax rate for both ordinary earnings and occasional earnings is 35%, calculate the profitability of the project.
Calculation of income and expenses
Sales, as well as operating expenses, will have an annual increase of 4%.
* It works with rounded values, especially when it comes to projected values.
Calculation of depreciation and Amortization
. Fixed assets are depreciated in a straight line with a useful life of 10 years
. Pre-operating expenses are amortized in a straight line over a period of 10 years.
Total annual depreciation and amortization = $ 9,000,000
Calculation of the cost of capital
Investors A and B have different opportunity rates and since the initial investment is covered between the two with individual contributions of 50%, it is required to calculate the cost of capital.
The capital cost is 16.50%, which represents the initial investment cost of $ 110,000,000.
Redemption value calculation.
It was explained in chapter 3, section 3.5.3, that the choice of the method to calculate the salvage value of an investment project depends, among other things, on what is expected to happen with the project at the end of the evaluation horizon and the evaluator criteria. If the project has a short useful life, it must coincide with the evaluation horizon and the method to calculate the surrender value must be the accounting or asset method. When the project has a long useful life, as in this case, the economic method should be used, based on the fact that the value of an asset, an investment project or a going concern is not defined by its book value but by the ability to generate cash flows.The economic value will be given by the present value of the cash flows expected to be generated by the investments during the useful life of the project, discounted at an opportunity interest rate or capital cost.
To calculate the salvage value of the project, applying the economic method, we divide the difference between the net cash flow of the last evaluation year (without taking into account the salvage value) and the depreciation between the discount rate, which can be the investor's opportunity rate or the cost of capital depending on how the initial investment is financed.
The cash flow of the project was built for a 5-year evaluation horizon without taking into account the salvage value. Depreciation and amortization of $ 9,000,000 were subtracted from the net cash flow of year 5 of $ 35,428,494l and the difference was divided by 16.50%, which is the cost of capital. When the economic method is used to calculate the salvage value of a project, the recovery value of working capital is not taken into account, since without this investment the company will not be able to continue generating cash flow.
Investment in working capital.
The investment in working capital in period zero is $ 20,000,000 and each year must be increased in real terms in a proportion equal to the expected inflation of 4% per year, which is the same expected increase in sales.
INVESTMENT IN WORKING CAPITAL
The investment in working capital for each evaluation year corresponds to the 4% increase over the investment of the previous year. Investments in working capital for each evaluation year are recorded in the cash flow as non-deductible expenses.
CALCULATION OF OPERATIONAL EXPENSES Operational
expenses are estimated at 5.0% of the value of sales
CASH FLOW OF THE PROJECT
CURRENT PRICES
The profitability of the project is 33.21% per year higher than the cost of capital (weighted average of the opportunity rates of investors A and B) of 16.50% per year.
CASE STUDY 6
Blanca Elena buys a house for $ 195,000,000 with the purpose of leasing it through a real estate agency that charges her a commission of 10% on the value of the rental fee defined as $ 2,000,000 per month during the first year, which is will increase by 3% per year corresponding to the expected inflation for the next 5 years. The house is expected to be sold at the end of year 5 for $ 212,500,000 taking into account the valuation of the sector. The annual value of the property tax is equivalent to 1.2% of the cadastral appraisal, which is $ 120,000,000. The house will depreciate in a straight line with a useful life of 20 years. If the tax rate is 35% and Blanca Elena's opportunity rate is 14% effective annually, determine if she did a good or bad deal.
SOLUTION
Calculation of annual rental income.
The lease fee is $ 2,000,000 per month for the first year. The evaluation horizon has been defined in 5 years and the cash flow of the project will be built for annual periods, therefore, the value of the monthly leases must be annualized.
First year lease value: $ 2,000,000 X 12 = $ 24,000,000
second year lease value: $ 2,000,000 X (1 + 0.03) X 12 = $ 24,720,000
Third year lease value: $ 2,000,000 X (1 +0.03) 2 X 12 = $ 25,461,600
Fourth year lease value: $ 2,000,000 X (1 + 0.03) 3 X 12 = $ 26,225,448
Fifth year lease value: $ 2,000,000 X (1 + 0.03) 4 X 12 = $ 27,012,211
Calculation of the value of annual net leases:
Calculation of depreciation
The house depreciates in a straight line, so the annual depreciation charge is $ 9,750,000 resulting from dividing the purchase value by its useful life.
Property tax calculation Property
tax = $ 120,000,000 X 0.012 = $ 1,440,000 Redemption
value calculation
Sales value = $ 212,500,000 Book
value = Purchase value - accumulated depreciation Book
value = $ 195,000,000 - (5 X $ 9,750,000) = $ 146,250,000
The expected sale value is greater than the book value, indicating that an occasional profit of $ 66,250,000 is expected, which is recorded in the project cash flow as taxable income and book value as nontaxable income.
PROJECT CASH FLOW
CURRENT PRICES
You get a NPV of $ - 34,201,132.06 less than zero and an IRR of 8.71% per year lower than the opportunity rate of Blanca Elena, which indicates that she did bad business.
CASE STUDY 7
For the project of case study 9, Blanca Elena decides to buy the house with a housing credit to the UVR + 10%, with a term of 5 years and payable through the UVR fixed fee system. Define:
a) How does the profitability of the project change?
b) What form of home acquisition is best for you?
SOLUTION
This is one of the few cases of investment projects, not to mention the only one, in which the initial investment of the project is financed 100% with liabilities.
Remember that there are three ways to finance an investment project:
1. With investor resources. The discount rate is your opportunity rate.
2. With liabilities. The discount rate is the cost of credit
3. With a mix of liabilities and equity. The discount rate is the cost of capital.
For this project, the UVR fixed fee system has been set as the amortization system. By expressing the credit rate in UVR plus a remuneration rate, the effect is to apply the inflation rate to the credit value and the remuneration rate to this adjusted value, resulting in the expression:
TE = (1 + INFLATION) (1 + i) - 1
Where: i = Remuneration rate TE = Cash cost of credit
The above expression calculates the cost of a home loan known as inflation and the remuneration rate. For this investment project, we have:
TEA = (1 + 0.03) (1 + 0.10) - 1 = 13.30% effective annual
The cost of credit after taxes is:
Kd = 0.1330 (1- 0.35) = 8.65% effective annual
The investment cost (discount rate) is 8.65% annual cash.
There is no distinction in project cash flow without financing and with financing. The difference in the financial evaluation of the project with and without financing is in the discount rate. For this project, to make the financial evaluation without financing, the opportunity rate of Blanca Elena is taken as a discount rate of 14% per year, and with financing, the discount rate is the net cost of credit of 8.65% per year.
CASH FLOW WITH FINANCING
CURRENT PRICES
You get a VPN of $ 479,014.85 and an IRR of 8.71% per year, therefore, now the project shows to be profitable. It is observed that the IRR obtained of 8.71% per year is the same that the financial evaluation of the project without financing showed (see case study 9), which indicates that the profitability of a project is independent of the way in which the investment is financed and, therefore, of the cost of it. What changes due to the effect of the use of credit is the decision to accept or reject the project. If Blanca Elena, given her expectations of profitability, buys the house with her own resources, the project is not profitable for her; If you buy it with a housing loan at that defined interest rate, now the project becomes profitable.
It is concluded, for obvious reasons, that the decision should be to acquire the house using the home loan.
As a complement to the document «Financial evaluation of investment projects. 7 case studies »we suggest the following video, in which Professor Jorge Ignacio Lardizábal, from Austral University, explains how entrepreneurs do to assess whether or not they carry out investment projects. Good theoretical material to continue learning about the financial evaluation of projects.
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