Lec. 06: Financial Management Flashcards
Explain the balance sheet model of a firm.
Total value of assets
Balance sheet model of a firm
- Balance sheet
–> Total assets must equal liabilities (“Passiva”) owed to others plus equity
Current assets
+
Non-current assets:
1. Tangible (“materiell”) non-current assets
2. Intangible (“immateriell”) non-current assets
=
Total value of assets
Current liabilities
+
Non-current liabilities
+
Shareholders’ equity
=
Total value of the firm to investors
Total value of the firm to investors
Current assets - current liabilities = Net working capital
Balance sheet
Provide examples.
Assets
- Current assets
- Non-current assets
Financing
- Current liabilities
- Non-current liabilities
- Equity (assets minus liabilities)
Balance sheet
Assets
- Current assets
–> Bank account, money owned by customers, securities - Non-current assets
–> Buildings and land, machinery, intellectual property
Financing
- Current liabilities
–> Short-term debt, money owned to suppliers - Non-current liabilities
–> Long-term debt, pension liabilities - Equity (assets minus liabilities)
–> Investor equity, reserves, profit from previous years
Name static methods of project evaluation.
Static methods of project evaluation
(Single period)
- Cost comparison
–> E.g. per year: operating costs plus average annual capital costs plus depreciation per year - Profit comparison
–> E.g. per year: revenue minus costs - Return on investment
–> ROI = EBIT/(average capital employed per year
–> EBIT = earnings before interest and tax - Payback period
–> Break-even = investment/(average cash flow per year)
Name dynamic methods of project evaluation.
Dynamic methods of project evaluation
(Using time value of money)
Net present value
- NPV: sum of discounted cashflows CF_t incl. CF_0 in t = 0
- Compares a given investment project with CF_t with an equivalent alternative investment project with an interest rate r
- NPV > 0 –> Invest in given investment project (CF_t)
Internal rate of return
- NPV(i = IRR) = 0
- Calculates the interest rate IRR for which an investor would be indifferent between investing in the given project with CF_t and an alternative investment option with an interestrate of r
- r < IRR –> Invest in given investment project (CF_t)
Equivalent annual annuity
- Converts the initial investment I_0 into an identical annual payment a which can be compared to the annual cashflow CF
- CF - a > 0 –> Invest in given investment project (CF_t)
What is missing?
To allow comparison between income and outgoings in different years, we need to agree on a particular point in time to evaluate the cash flows.
The simplest and most frequently used time point: today’s value, known as the “…”.
For “…” r we multiply the income or outgoings in year t by the “…” 1/(1+r)^t to calculate the present value.
We have “…” the future cash flow.
Future income or outgoings are worth less from today’s point of view (as long as r is positive). “Money in the future is worth less than money today.”
“…” takes the present value to the future value.
“…” takes the future value to the present value.
“present value (= “Barwert”)”
“an interest rate”
“discount factor”
“discounted”
“Compounding (= “Aufzinsen”)”
“Discounting (= “Abzinsen”)”
Dynamic investment calculation: NPV method
Present and explain the formula.
NPV method
- Discounts all cashflows to the present (t = 0) and construct net present value (NPV)
- NPV > 0? –> Investment is worthwhile compared to investing with interest rate r!
–> See formula on slide 17
r: Hurdle rate or required rate of return
CF_t: Cashflow in t (income_t - outgoings_t)
I_t: Capital expenditure in t
V_t: Consumption costs in t
(E.g. variable O&M cots; fuel cost o_t and annual production Q_t; Vt = o_t · Q_t)
B_t: Operating costs in t (= Fix O&M)
U_t: Income in t
(E.g. average market value p_t times annual production Q_t , U_t = p_t · Q_t)
Dynamic investment calculation: NPV method
True or false?
If NPV > 0, the investment is worthwhile.
If NPV < 0, better to invest with a rate of return of r elsewhere.
For comparisons between different investments, a higher NPV should be preferred.
True!
Name the relevant cashflows from financing and from operating activities.
Relevant cashflows from financing activities
- Capital expenditures
- Sale of assets
Relevant cashflows from operation activities
- Revenues
- Operating expenses
- Depreciation
- Taxes
- Change in working capital
What are opportunity costs?
Provide an example.
Opportunity costs
- Potential benefits/income of the next best alternative that is forgone when making a decision
- It represents the benefit/income you could have received by choosing a different option
- E.g. Roof taken by solar PV unit could have been used for solar thermal water heating
What are sunk costs?
Provide an example.
Sunk costs
- Cost incurred in the past which cannot be changed by any decision anymore and are therefore ignored
- E.g. once you have bought and installed the PV unit, there is no point taking the purchase of the PV unit into the NPV calculation
What is the salvation value?
Provide an example.
Salvation value
- It is the estimated residual value of an asset at the end of its economic lifetime
- E.g. Selling the PV unit to a neighbouring firm.
What is the depreciation tax shield?
Depreciation tax shield
- Yearly depreciation amount is deducted from the income tax base.
- The resulting tax saving [depreciation amount x tax rate] is added as a positive cash flow
If investments only occur in the first year, and the costs and income for the following years are constant, we can simplify the NPV formula.
Present and explain the formula.
–> Compare slide 21
NPV = [U-I-V-B] * PVF(r,T) = [U-I-V-B] * 1/r [1-1/(1+r)^T]
Present Value Factor PVF(r,T)
PVF(r,T) = 1/r [1-1/(1+r)^T]
- Brings a series of equal payments g = U − V − B to the present value so that they can be compared with the initial investment I_0
- Can be taken from standardized tables
Internal rate of return (IRR) method
Present and explain the formula.
The Internal Rate of Return (IRR)
- Is the required hurdle rate to reach the point NPV = 0
Invest?
- Hurdle rate <= IRR –> Invest in project!
Formula
NPV = 0
0 = -I_0 + (U - V - B) * PVF(r,T)
- Solve for PVF(r,T), than look PVF(r,T) up in table using the given T to determine r
- Compare slide 25
Annuity method
Present and explain the formula.
Annuity method
- Converts investment into identical annual payments a, so that they’re comparable with the cashflows
Invest?
- CF - a > 0? –> Invest!
Annuity
- a = I_0 / PVF(r,T) = a(r,T) * I_0
- a: Annualised investment cost
Annuity factor
- a(r,T) = 1/PVF(r,T) = r/(1-(1+r)^T)
- Spreads the capital costs I0 evenly over the operational years of the investment while taking account of the rate r
- Can be taken from standardized tables
Explain the hurdle rate.
Provide the formula.
Hurdle rate
- Represents cost of capital and project risk
Hurdle rate = risk-free interest rate (e.g. from government bonds) + risk premium
Explain the Weighted Average Cost of Capital (WACC).
Provide the formula.
Weighted Average Cost of Capital
- Is the cost of capital weighted by its source which is made up of the interest rate of the debt capital (“FK”) and the return on equity of the shareholder’s equity (“EK”)
WACC = E / (E + D) * r_e + D / (E + D) * r_d * (1 - t)
E: Market value of equity
D: Market value of debt
r_e: Return on equity
r_d: Debt interest rate
t: Corporate tax rate
- The amount of interest paid on debt is deducted from the taxable income. This reduces the income tax paid by the company
True or false?
WACC for a PV project also depends on each country’s risk profile and the experience of local investors with the technology, which can improve as the technology becomes established.
True!
What is the debt-to-equity ratio?
Debt-to-equity ratio: D/E
What is the leverage effect?
Leverage effect
- We use debt to leverage our equity to get a higher return on equity
r_e = r_total + (r_total - r_d) * D/E
True or false?
Over long time periods the discount factor ( = CF_t/(1+r^t)) decreases exponentially
- Long-term benefits are suppressed
–> E.g. long production life of nuclear power plants or benefits of long-lived efficiency measures - Long-term costs are suppressed
–> E.g. decommissioning, waste disposal, climate damages
True!
Long-term costs or benefits are suppressed by discounting!
Explain the connection of the real interest rate and the inflation rate.
1 + nominal interest rate = (1 + real interest rate) * (1 + inflation rate)
What is the difference between the nominal cash flow and the real cash flow?
Nominal cash flow vs. real cash flow
Nominal cash flow
- Actual money in cash to be received / paid
- Nominal cash flows must be discounted using the nominal rate
Real cash flow
- Purchasing power of cash flow
- Real cash flows must be discounted using the real rate
Provide a possible reason why the WACC of a specific technology (e.g. gas turbine) is higher than different technologies (e.g. pv and wind).
Example
Longer investment periods –> increased uncertainty (~ risk)(due to e.g. raising CO2 prices) –> captial providers expect higher rate of return –> increased capital costs –> increased WACC
- Investors compensate for this risk by asking for higher rates of return (= “Rendite”) which in turn leads to higher capital costs
Levelised Cost Of Energy (LCOE)
Levelised Cost Of Energy (LCOE)
- Average electricity price/market value p (= LCOE) over the lifetime of a specific investment for which this investment has a NPV = 0
- Also called Long-Run Marginal Cost (LMRC)
- Solve for p
0 = NPV = −I_0 +(pQ - oQ - B) * PVF(r,T)
Formula
- You can calculate the LCOE with or without the peak capacity of the power plant!
p = LCOE = 1/Q * (I_0 * a(r,T) + B) + o
(If Q [kWh]; I_0 [€]; B[€]; o [€/kWh])
p = LCOE = 1/q * (i_0 * a(r,T) + b) + o
(If q [h] = FLH [h]; I_0 [€/kW]; B[€/kW]; o [€/kWh])
How do you calculate the annual cost per unit capacity [€/kW_peak] of a power plant using the LCOE?
Annual cost per unit capacity [€/kW_peak] of a power plant
AC = LCOE * Q/G = LCOE * CF * 8760h = LCOE * FLH
(In this case: Q [kWh], [MWh]; G [kW], [MW])
LCOE
True or false?
LCOE of dispatchable generators decreases with an increasing capacity factor.
True!
LCOE
Given:
- PV LCOE in Spain = 0,045 €/kWh
- PV LCOE in Germany = 0,072 €/kWh
- Electricity retail prices in Spain and Germany are 0,30 €/kWh
- Feed-in tariff (FIT) of 0,12 €/kWh in Spain and Germany
What does this imply for the self-consumption of the generated electricity?
What does this imply for the self-consumption of the generated electricity?
Supply though grid vs. supply through own generation
- Retail price > LCOE
- Self-consumption is more cost efficient than being supplied via the grid
Self-consumption vs. grid injection
- Self-consumption savings (retail price - LCOE) > FIT
- It is more profitable to consume the generated electricity due to the high retail price than to inject the generated electricity into the grid
To Further increase the already high profitability of self-consumption:
- Invest in battery storage or DSM to further align self generation and own demand pattern
What is the difference between real and financial options?
Financial options theory has been applied to physical investments.
Financial options
- Are the right to buy [or sell] the underlying asset at a specified price during [or at] a specified time.
- Option holder pays option premium to option writer.
Real options
- Are physical investments that allow the owner the option to do something (e.g. sell or buy a commodity) in the future.
- E.g. investments in an offshore oil platform
What are real options once the final investment decision (FID) has been made?
Options to make adjustments to the project once it is accepted based on new information
- Delay investment until an uncertainty disappears (timing option)
- Change (expand/reduce) the scale of the project
- Change the in-/output of the project
- Divestment
True or false?
Real options versus NPV method
NPV method
- More uncertain assets have relatively less economic value ⇒ riskier investments are penalised by higher discount rates
Real options theory
- Uncertainty means not only possibility of future loss but also opportunity to create value from flexibilities by adapting the project to evolving conditions
True!
True or false?
Decision tree method is used for modelling sequential decision problems under uncertainty.
Decisions
- Mutually exclusive and collectively exhaustive set of possible alternatives of
courses of action
Events
- Mutually exclusive and collectively exhaustive set of possible outcomes (states of nature) with assigned probabilities. The sum of probabilities in a set of events is equal to one.
Payoffs
- Sum of costs and revenues associated with an alternative
True!
True or false?
Decision tree method
- Make a decision based on the expected value of each branch.
True!
True or false?
Oil and gas upstream industry is characterised by sequential investment decisions. Therefore the decision tree method can be applied here.
True!
True or false?
Real options: Application examples
- Oil and gas exploration and production projects
- Developing a new technology ⇒ high R&D cost and risk
- Change in regulation, e.g. climate policies ⇒ future CO2 price
True!
