CrossBorder Infrastructure A Toolkit Financial Analysis Session on

Cross-Border Infrastructure: A Toolkit Financial Analysis Session on Finance Sidharth Sinha Indian Institute of Management, Ahmedabad The views expressed here are those of the presenter and do not necessarily reflect the views or policies of the Asian Development Bank (ADB), or its Board of Directors, or the governments they represent.

Cross-Border Infrastructure: A Toolkit Time Value of Money • Money received today is not the same as money to be received in the future. Æ Money received today can be invested to earn a return. Æ Money to be received in the future is also uncertain • Discounting is the process of adjusting the value of money to be received in the future for time value and risk. • The discounted value is called present value.

Cross-Border Infrastructure: A Toolkit Present Values • Present value of $1 to be received at the end of 1 year if the discount rate is 10% The higher the discount rate, the lower the present value. • The discount rate is the opportunity cost of not having money now. • This is the rate you could have earned if you had the money now instead of later.

Cross-Border Infrastructure: A Toolkit Present Values • Present value of $1 to be received at the end of 2 years • This is also known as the discount factor for 2 years at 10% The longer the time period to receiving the money, the lower the present value.

Cross-Border Infrastructure: A Toolkit Present Values • Present value of $1 to be received at the end of t years at a discount rate of 10% • This is also known as the discount factor for t years at 10%

Cross-Border Infrastructure: A Toolkit Present Values • Present value of $10 to be received at the end of 2 years Present Value = Cash Flow*Discount Factor

Cross-Border Infrastructure: A Toolkit Present Values Example - • You just bought a new computer for $3, 000. The payment terms are 2 years same as cash. If you can earn 8% on your money, how much money should you set aside today in order to make the payment when due in two years?

Cross-Border Infrastructure: A Toolkit Present Values • PVs can be added together to evaluate multiple cash flows.

Cross-Border Infrastructure: A Toolkit Present Values • PVs can be added together to evaluate multiple cash flows. • Discount rate is 7. 7%

Cross-Border Infrastructure: A Toolkit Present Values $200 $100 Present Value Year 0 0 100/1. 077 = $92. 85 200/1. 0772 = $172. 42 Total = $265. 27 1 2 Year

Cross-Border Infrastructure: A Toolkit Net Present Values (NPV) Example - • Assume that the cash flows from the construction and sale of an office building is as follows. Given a 5% required rate of return, create a present value worksheet and show the net present value. • When there are both positive and negative cash flows the term Net Present Value is used.

Cross-Border Infrastructure: A Toolkit Present Values Example (continued) • Assume that the cash flows from the construction and sale of an office building is as follows. Given a 5% required rate of return, create a present value worksheet and show the net present value.

Cross-Border Infrastructure: A Toolkit Present Values Example (continued) • Assume that the cash flows from the construction and sale of an office building is as follows. Given a 5% required rate of return, create a present value worksheet +$320, 000 and show the net present value. -$100, 000 Present Value -$170, 000 Year 0 0 -170, 000 -100, 000/1. 05 320, 000/1. 052 Total = NPV = -$170, 000 = $95, 238 = $290, 249 = $25, 011 1 2

Cross-Border Infrastructure: A Toolkit Internal Rate of Return Example - • You can purchase a machine tool for $4, 000. The investment will generate $2, 000 and $4, 000 in cash flows for two years, respectively. What is the IRR on this investment? • Internal Rate of Return is that discount rate which makes the Net Present Value of the cash flows equal to 0.

Cross-Border Infrastructure: A Toolkit Internal Rate of Return Example (continued) - • You can purchase a machine tool gadget for $4, 000. The investment will generate $2, 000 and $4, 000 in cash flows for two years, respectively. What is the IRR on this investment?

Cross-Border Infrastructure: A Toolkit Internal Rate of Return Example • You can purchase a machine tool for $4, 000. The investment will generate $2, 000 and $4, 000 in cash flows for two years, respectively. What is the IRR on this investment? • IRR is that discount rate which makes the NPV equal to 0. • “Break-even” discount rate

Cross-Border Infrastructure: A Toolkit Internal Rate of Return IRR=28%

Cross-Border Infrastructure: A Toolkit Net Present Value • Present value of cash flows at 20% discount rate • Since 20% < IRR project has a positive NPV

Cross-Border Infrastructure: A Toolkit Project Evaluation • Forecast after tax free cash flows • Estimate appropriate discount rate • Calculate net present value (NPV) Æ Accept if NPV > 0 • Calculate IRR Æ Accept if IRR > discount rate

Cross-Border Infrastructure: A Toolkit Expected Free Cash Flow • Profit before interest and tax (PBIT) Æ - tax Æ + depreciation Æ =cash from operations Æ Working capital investment Æ Necessary capital expenditure Æ = Free cash flow • Cash flow available to pay capital providers - equity & debt investors • Cash flows are uncertain - valuation is based on expected cash flows

Cross-Border Infrastructure: A Toolkit Weighted Average Cost of Capital (WACC) • Weighted average cost of capital (WACC) Æ= Cost of equity * prop of equity Æ +Cost of debt * (1 -tax rate)*prop of debt • Proportion of equity Æ= Equity / (Equity + Debt) • Proportion of debt Æ= Debt / (Equity + Debt) • Cost of debt = interest rate paid on debt

Cross-Border Infrastructure: A Toolkit Cost of Equity • Dividend yield + capital gains Æ Dividend Æ Capital yield = % (dividend per share /share price) gains = % increase in share price • Required return on equity Æ= risk free rate + risk premium for equity • Costs of debt, equity and WACC depend on the risk of cash flows Æ Investors projects require higher rates of return for riskier

Cross-Border Infrastructure: A Toolkit Enhancing Viability • Increase level of expected free cash flow Æ Increase revenues Æ Reduce costs • Reduce WACC by reducing risk of cash flows

Cross-Border Infrastructure: A Toolkit Inflation • Inflation - rate at which prices as a whole are increasing. • Nominal Interest Rate - rate at which money invested grows. • Real Interest Rate - rate at which the purchasing power of an investment increases.

Cross-Border Infrastructure: A Toolkit Inflation • Approximation Formula • Real int. rate ≈ nominal int. rate - inflation rate

Cross-Border Infrastructure: A Toolkit Inflation Example • If the interest rate on one year govt. bonds is 5. 9% and the inflation rate is 3. 3%, what is the real interest rate? 1 + real interest rate = 1+. 059 1+. 033 1 + real interest rate = 1. 025 Real interest rate =. 025 or 2. 5% Approximation =. 059 -. 033 =. 026 or 2. 6%

Cross-Border Infrastructure: A Toolkit • Nominal cash flow forecasts take into account changes in prices of cash flows. • Real cash flows assume constant price level.