Accounting Principles and Evaluation Criteria of Projects

Economic evaluations in chemical industry emerge from the need to select between a large number of options on how and where to manufacture a certain product. The amount of capital invested in a new manufacturing facility is based on estimates. Working capital needs to be provided as well before income from sales is obtained. When profit is made tax payments are applicable.

During the life-span of a manufacturing facility the initial investment has to be earned back. Thus, depreciation is a compensation included in the costs of goods sold (cost price of product), which reduces yearly the actual value of the manufacturing assets or ‘’book value’’. Since depreciation is a fixed cost, it is subtracted from the revenues of sales and consequently the taxable income is decreased. Two depreciation methods are of common use:

Straight line depreciation

Double declining balance depreciation

D: Annual depreciation

N: life span in years

I: Initial investment

R: Salvage value

In the second method, depreciation is calculated as a fraction from the book value, and in the first year, it is twice as in the first method. Accelerated depreciation is useful when high risk projects are carried out.

In the financial report of a company, a balance sheet states the assets (current assets: inventories and accounts receivable; fixed assets: property, plant equipment and intangible goodwill) and the liabilities (current liabilities: accounts payable; fixed liabilities: bank loans). The difference between them is called equity. Working capital is the difference between current assets and current liabilities. Therefore:

 ASSETS=LIABILITIES + EQUITY

IQ Balance Sheet	Year 2010	Year 2009
		Million €
ASSETS
Current Assets
Cash	1300	1200
Acounts Recievable	3500	3000
Inventories	5000	4500
Total Current Assets	9800	8700
Fixed Assets
Property, Plant, Equipment	19500	18500
Accumulated Depreciation	10200	9700
Book Value	9300	8800
Intangible Assets	1300	1000
Total Fixed Assets	10600	9800
Total Assets	20400	18500
LIABILITIES
Current Liabilities
Accounts Payable	3000	2500
Short Term Loans	1000	900
Total Current Liabilities	4000	3400
Fixed Liabilities
Long Term Loans	7900	8300
Total Fixed Liabilities	7900	8300
Total Liabilities	11900	11700
EQUITY
Total Equity	8500	6800
LIABILITIES+EQUITY	20400	18500

There are several ratios to judge the financial performance of a company:

Often inventories are subtracted in the calculation of liquidity to determine the quick ratio of the company. Together with the income statement (which shows the yearly profit or loss of a company), the balance sheet provides other performance indicators:

IQ Income Statement	2010	2009
	Million €
Net Sales	24900	23700
Other income	900	1000
TOTAL	25800	24700
Costs of goods sold	19500	18400
Administative Services	2350	2000
Amortization of Intangible Assets	200	150
R&D expenses	1100	1000
Interest expenses	350	350
TOTAL	23500	21900
Pre-Tax Operating Income PTOI	2300	1800
Income Tax	500	400
After Tax Operating Income ATOI	1800	1400

*Note that interest is deducted before taxes.

The Cash Flow Statement explains the difference between the increase in equity from year 2009 to 2010 and the net income. This difference reflects the payment of dividends to shareholders.

IQ Cash Flow Statement	Year 2010	Year 2009
	Million €
OPERATING ACTIVITIES
Net Income	1800	1400
Depreciation	700	700
Amortization of Intangible Assets	150	150
Deferred Tax Benefit	0	50
Increase in accounts recievable	-250	-200
Increase in inventory	-150	-250
Increase in accounts payable	250	100
Cash Provided by Operating Activities	2500	1950
INVESTING ACTIVITIES
Purchase	-1500	-1300
Other	-150	0
Sales of Assets	0	150
Cash Used For Investing Activities	-1650	-1150
FINANCING ACTIVITIES
Dividends paid to shareholders	-400	-500
Increase in short-term borrowings	700	-300
Receipts of long-term borrowings	1500	1800
Payments of long term borrowings	-2500	-2300
buy-back of common stocks	-350	-200
Cash Used for Financing Activities	-1050	-1500
DECREASE IN CASH	-200	-700

In order for a company to finance a new facility, capital can be provided from inside: as retained profits, by selling assets (divestures) or by the emission of shares; and from outside, by means of bank loans. Financers make their profit with a fixed interest in the loans, while shareholders will be paid with dividends and with an increase in the market value of their shares. Therefore, capital provided is composed of bank loans and shareholders’ equity.

With the aim of avoiding deflation (or decrease in the general price level) that would cause stagnation of the economy, a slight inflation (or increase in the general price level) is established. As a result, the value of money is going down with time. One component of the interest of a loan compensates this loss of value: it is called real interest. Aditionally, a compensation for the risk of not being paid back is added to yield the nominal interest.

The cost of capital for a company of this mix between loans and shareholders’ equity is expressed in the Weighted Average Cost of Capital:

Shareholders run a bigger risk than banks and have a relatively high return of their capital. Interest expenses are tax deductible and as a result, the costs of bank loans for the company are lower.

The project carried out by a company has to generate profits in order to reward the providers of capital in terms of interest and dividends. An easy method to evaluate small projects is the pay-back time, or the time needed for the cumulative cash flow to equal the initial investment. Although the simplicity of the method is a great advantage, it doesn’t take into account the time value of money nor the operational life of the project. The present value of future cash flows is calculated by using the WACC as the discount rate to determine the discounted pay-back time of a project. The Net Present Value (NPV) is the cumulative discounted cash flows of a project at the end of its operational life. The profitability index bears in mind the total initial investment, in order to compare different projects:

 The following example illustrates these parameters:

Year	Nominal Cash Flow	Cumulative Cash Flow	Discounted Cash Flow	Cumulative Discounted Cash Flow
0	-200	-200	-200	-200
1	-1000	-1200	-893	-1093
2	300	-900	239	-854
3	300	-600	214	-640
4	300	-300	191	-450
5	300	0	170	-279
6	300	300	152	-127
7	300	600	136	8
8	300	900	121	130
9	300	1200	108	238
10	300	1500	97	334
11	300	1800	86	421
12	-100	1700	-26	395

WACC	12%
Pay Back Time	5 y.
Discounted Pay Back Time	7 y.
NPV	395
PI	0,36

The negative cash flows extend at the beginning of the project reflecting different payments (e.g. engineering, equipment and construction), while at the end of the project life a negative cash flow is shown due to dismantling costs.

The discount rate that yields a net present value of 0 is called the Internal Rate of Return (IRR), the most common criterion to determine the feasibility of a project. If the IRR is greater than the WACC or hurdle rate the project is considered acceptable. Working with the example above, representing the values of the NPV for different discount rates:

Which reveals that the IRR for this IQ Project example is 20%.

Arnaiz