Financial management
Lecture 1
1. Understand and explain the difference between the three core disciplines in
financial management (i.e., finance, management accounting, and financial
accounting);
2. Define ‘capital budgeting’ and the time value of money;
3. Evaluate the connection between free cash flows and profits;
4. Assess investment projects based on a range of techniques (i.e., accounting rate of
return, payback period, net present value, and internal rate of return);
5. Interpret the differences between these assessment techniques.
1. Capital budgeting
a. Capital budgeting, free cash flows, and profits
Capital budgeting (investment appraisal) = the process in which an organization determines
whether investments (such as opening a new branch, replacing a machine, investing in R&D)
are worth pursuing
● Assessing whether it is worthwhile to invest in a particular project
● Choosing between different projects
● Replacement vs. expansion investments
Free cash flow = Difference between:
● Cash inflows, generated by sales and other income directly resulting from the investment
● Cash outflows, generated by purchasing of resources related to the investment, rent,
corporate taxes, etc.
● Includes initial investment and disinvestment (=Residual value of the investment)
Free cash flow Period profit after tax + depreciation – investments +
disinvestments
Start of project Free cash flow = - investment
During project Free cash flow = period profit after tax + depreciation
End of project Free cash flow = period profit after tax + depreciation +
disinvestment
Example
You are the leader of a project on manufacturing eco-friendly cutlery. You have
gathered the following data regarding your machinery in the coming year:
● Sales: €3,750
● Operating costs: €1,250
● Operating costs do not include depreciation
, ● Depreciation: €450
● The tax rate is 25%
● In the coming year, there are no other (dis-)investments
Free cash flow = period profit after tax + depreciation
● So, first calculate period profit after tax
● Profit before tax : 3,750 (sales) – 1,250 (operating costs) - 450 (depreciation) =
2,050
● Profit after tax: 2,050 – 0.25*(2,050) = 1,537.50
● Add depreciation to determine the free cash flow: 1,537.50 + 450 = 1,987.50
Free cash flow = € 1,987.50
Period profit (‘accounting income’, ‘net income’) = Difference between period sales and costs
associated with an investment
Depreciation = Intention: Distribute costs of assets over the years in which the asset is used
b. Assessment based on period profit: accounting rate of return
Accounting Rate of Return (ARR):
● Compare with ‘weighted average cost of capital’ (WACC):
● Average cost against which a company can attract capital
● Ignores distribution of free cash flows over duration of the project
ARR 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑝𝑟𝑜𝑓𝑖𝑡
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 (𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒)
Average profit Σ Period profits / Duration in years
Average invested capital (average book value) (Initial investment + Residual value)/2
c. Assessment based on free cash flows: payback period
Payback Period:
● Period between the original investment and the cash inflows up to the amount of the
investment
● Very crude measure, only partially accounts for timing of free cash flows, does
not account for free cash flows after the payback period, and no clear cut-off point\
● Not very suitable for projects
d. Assessment based on free cash flows, taking into account time value of money: net present
value and internal rate of return
Time value of money:
Future value If you save €1,000 for 4 years @ 5%
Compound interest rate (compound interest), its future value is:
€ 1,000*(1.05*1.05*1.05 *1.05) =
, € 1,000*(1.05)4= € 1,215.51
Present value If you want to receive €1,000 in 4 years @
Discount rate 5% (discount rate), its present value would
be:
€ 1,000/(1.05*1.05*1.05*1.05) =
€ 1,000/(1.05)4= € 822.70
Net Present Value:
Present value of all expected future free cash flows, including the initial investment
(disinvestment is included in free cash flow of final year)
● Discount rate: WACC
● If NPV > 0 àproject warrants further consideration!
Example
You are the CEO of a well-known firm of architects. At the eve of the firm’s 50th anniversary,
you have asked two teams of employees to pitch a (multi-year) project to put the firm in the
spotlight. Calculate the NPV of both projects (WACC: 8%).
A. Pop-up exhibit in gallery in busy shopping street (3 years)
B. 3D-prints of most-famous accomplishments, to be sold (4 years)
- NPVA(€ 1,000)
= -500 + 150/(1.08) + 200/(1.08)2+ 400/(1.08)3
= -500 + 138.89 + 171.47 + 317.53
= 127.89
- NPVB(€ 1,000)
= -300 + 100/(1.08) + 100/(1.08)2+ 100/(1.08)3 + 200/(1.08)4
= 104.72
- NPV of both projects is > 0, so both warrant further consideration
- NPVA > NPVB, so project A should be preferred
Example
A real estate developer has the opportunity to buy a piece of land. His desired return (WACC)
is 14% in not more than 4 years. The initial investment is estimated at € 340,000. The free
cash flows in the first four years are as follows:
• Year 1: € 50,000
• Year 2: € 55,000
• Year 3: € 55,000
• Year 4: € 415,000
Calculate NPV by determining the sum of the initial investment and the expected discounted
future free cash flows:
• NPV = -340 + 50/(1.14) + 55/(1.14)2+ 55/(1.14)3+ 415/(1.14)4
= 29.017
Internal rate or Return (IRR)
Discount rate where the NPV of a project equals zero
● If IRR > WACC (interest rate), project is acceptable
, ● To determine IRR: trial and error OR just by Excel
Example
- IRRA(€ 1,000)
0 = -500 + 150/(1+i) + 200/(1+i)2+ 400/(1+i)3
i = 0.19
- IRRB(€ 1,000)
0 = -300 + 100/(1+i) + 100/(1+i)2+ 100/(1+i)3
+ 200/(1+i)4
i = 0.21
- IRR of both projects is > WACC (8%), so both warrant further consideration
- IRRB > IRRA, so project B should be preferred
Net Present Value (NPV) vs. Internal Rate of Return (IRR)
● NPV and IRR sometimes give seemingly contradictory results
● NPV does not measure the rate of return and tends to favor projects with a longer
duration
● IRR assumes that free cash flows received before the end of the project can be
investedduring the remaining period with a return equal to the IRR. For high IRRs, this is
dubious.
● In practice, people may prioritize NPV (at least greater than zero) and then consider IRR.
e. Assessment of assessment techniques
Uncertainty = Future free cash flows are only estimates, not known in advance
Sensitivity analysis= Analysis of the effect of change in sales/costs on profit and cash flows
E.g.: optimistic and pessimistic scenarios
Risk premium = Adding a premium to the discount rate
2. Working capital management
Working capital = Resources available to the organization for day-to-day operations
● Organizations’ need a sufficient level
● Liquidity; financial health of the organization
● Investment opportunities; operational health of the organization
● BUT... not too much! → Efficient management of financial resources
Lecture 1
1. Understand and explain the difference between the three core disciplines in
financial management (i.e., finance, management accounting, and financial
accounting);
2. Define ‘capital budgeting’ and the time value of money;
3. Evaluate the connection between free cash flows and profits;
4. Assess investment projects based on a range of techniques (i.e., accounting rate of
return, payback period, net present value, and internal rate of return);
5. Interpret the differences between these assessment techniques.
1. Capital budgeting
a. Capital budgeting, free cash flows, and profits
Capital budgeting (investment appraisal) = the process in which an organization determines
whether investments (such as opening a new branch, replacing a machine, investing in R&D)
are worth pursuing
● Assessing whether it is worthwhile to invest in a particular project
● Choosing between different projects
● Replacement vs. expansion investments
Free cash flow = Difference between:
● Cash inflows, generated by sales and other income directly resulting from the investment
● Cash outflows, generated by purchasing of resources related to the investment, rent,
corporate taxes, etc.
● Includes initial investment and disinvestment (=Residual value of the investment)
Free cash flow Period profit after tax + depreciation – investments +
disinvestments
Start of project Free cash flow = - investment
During project Free cash flow = period profit after tax + depreciation
End of project Free cash flow = period profit after tax + depreciation +
disinvestment
Example
You are the leader of a project on manufacturing eco-friendly cutlery. You have
gathered the following data regarding your machinery in the coming year:
● Sales: €3,750
● Operating costs: €1,250
● Operating costs do not include depreciation
, ● Depreciation: €450
● The tax rate is 25%
● In the coming year, there are no other (dis-)investments
Free cash flow = period profit after tax + depreciation
● So, first calculate period profit after tax
● Profit before tax : 3,750 (sales) – 1,250 (operating costs) - 450 (depreciation) =
2,050
● Profit after tax: 2,050 – 0.25*(2,050) = 1,537.50
● Add depreciation to determine the free cash flow: 1,537.50 + 450 = 1,987.50
Free cash flow = € 1,987.50
Period profit (‘accounting income’, ‘net income’) = Difference between period sales and costs
associated with an investment
Depreciation = Intention: Distribute costs of assets over the years in which the asset is used
b. Assessment based on period profit: accounting rate of return
Accounting Rate of Return (ARR):
● Compare with ‘weighted average cost of capital’ (WACC):
● Average cost against which a company can attract capital
● Ignores distribution of free cash flows over duration of the project
ARR 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑝𝑟𝑜𝑓𝑖𝑡
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 (𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒)
Average profit Σ Period profits / Duration in years
Average invested capital (average book value) (Initial investment + Residual value)/2
c. Assessment based on free cash flows: payback period
Payback Period:
● Period between the original investment and the cash inflows up to the amount of the
investment
● Very crude measure, only partially accounts for timing of free cash flows, does
not account for free cash flows after the payback period, and no clear cut-off point\
● Not very suitable for projects
d. Assessment based on free cash flows, taking into account time value of money: net present
value and internal rate of return
Time value of money:
Future value If you save €1,000 for 4 years @ 5%
Compound interest rate (compound interest), its future value is:
€ 1,000*(1.05*1.05*1.05 *1.05) =
, € 1,000*(1.05)4= € 1,215.51
Present value If you want to receive €1,000 in 4 years @
Discount rate 5% (discount rate), its present value would
be:
€ 1,000/(1.05*1.05*1.05*1.05) =
€ 1,000/(1.05)4= € 822.70
Net Present Value:
Present value of all expected future free cash flows, including the initial investment
(disinvestment is included in free cash flow of final year)
● Discount rate: WACC
● If NPV > 0 àproject warrants further consideration!
Example
You are the CEO of a well-known firm of architects. At the eve of the firm’s 50th anniversary,
you have asked two teams of employees to pitch a (multi-year) project to put the firm in the
spotlight. Calculate the NPV of both projects (WACC: 8%).
A. Pop-up exhibit in gallery in busy shopping street (3 years)
B. 3D-prints of most-famous accomplishments, to be sold (4 years)
- NPVA(€ 1,000)
= -500 + 150/(1.08) + 200/(1.08)2+ 400/(1.08)3
= -500 + 138.89 + 171.47 + 317.53
= 127.89
- NPVB(€ 1,000)
= -300 + 100/(1.08) + 100/(1.08)2+ 100/(1.08)3 + 200/(1.08)4
= 104.72
- NPV of both projects is > 0, so both warrant further consideration
- NPVA > NPVB, so project A should be preferred
Example
A real estate developer has the opportunity to buy a piece of land. His desired return (WACC)
is 14% in not more than 4 years. The initial investment is estimated at € 340,000. The free
cash flows in the first four years are as follows:
• Year 1: € 50,000
• Year 2: € 55,000
• Year 3: € 55,000
• Year 4: € 415,000
Calculate NPV by determining the sum of the initial investment and the expected discounted
future free cash flows:
• NPV = -340 + 50/(1.14) + 55/(1.14)2+ 55/(1.14)3+ 415/(1.14)4
= 29.017
Internal rate or Return (IRR)
Discount rate where the NPV of a project equals zero
● If IRR > WACC (interest rate), project is acceptable
, ● To determine IRR: trial and error OR just by Excel
Example
- IRRA(€ 1,000)
0 = -500 + 150/(1+i) + 200/(1+i)2+ 400/(1+i)3
i = 0.19
- IRRB(€ 1,000)
0 = -300 + 100/(1+i) + 100/(1+i)2+ 100/(1+i)3
+ 200/(1+i)4
i = 0.21
- IRR of both projects is > WACC (8%), so both warrant further consideration
- IRRB > IRRA, so project B should be preferred
Net Present Value (NPV) vs. Internal Rate of Return (IRR)
● NPV and IRR sometimes give seemingly contradictory results
● NPV does not measure the rate of return and tends to favor projects with a longer
duration
● IRR assumes that free cash flows received before the end of the project can be
investedduring the remaining period with a return equal to the IRR. For high IRRs, this is
dubious.
● In practice, people may prioritize NPV (at least greater than zero) and then consider IRR.
e. Assessment of assessment techniques
Uncertainty = Future free cash flows are only estimates, not known in advance
Sensitivity analysis= Analysis of the effect of change in sales/costs on profit and cash flows
E.g.: optimistic and pessimistic scenarios
Risk premium = Adding a premium to the discount rate
2. Working capital management
Working capital = Resources available to the organization for day-to-day operations
● Organizations’ need a sufficient level
● Liquidity; financial health of the organization
● Investment opportunities; operational health of the organization
● BUT... not too much! → Efficient management of financial resources
