lunes, 28 de abril de 2014

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

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