Profitability Metrics, Payback Period Emily Riederer Instructor - - PowerPoint PPT Presentation

DataCamp Financial Analytics in R

Profitability Metrics, Payback Period

FINANCIAL ANALYTICS IN R

Emily Riederer

Instructor

DataCamp Financial Analytics in R

Profitability Metrics & Decision Rules

Key Concepts: Profitability Metrics: quantify how and when a project contributes value to a firm Decision Rules: interpret metrics for decisions & comparisons Interpretation affected by: Absolute ($) versus relative (%) value Constrained versus unconstrained decision-making

DataCamp Financial Analytics in R

Caveats of Decision Rules

All of shortcomings; look at multiple dimensions Called "rules" but not the law! Don't take into account all aspects of strategy

DataCamp Financial Analytics in R

Payback Period

Definition: Time it takes to recoup initial investment Decision Rule: Shorter payback period is preferable - especially when low on cash! Pitfalls: Doesn't consider time-value of money Doesn't consider actual profit

DataCamp Financial Analytics in R

Calculating Payback Period

n cashflow cumsum(cashflow)

• 10000
• 10000

1 2500

• 7500

2 3000

• 4500

3 5000 500 4 6000 6500 5 1000 7500

cashflows <- c(-10000, 2500, 3000, 5000, 6000, 1000) cumsum(cashflows) + init_investment

DataCamp Financial Analytics in R

Let's practice!

FINANCIAL ANALYTICS IN R

DataCamp Financial Analytics in R

NPV, IRR, and Profitability Index

FINANCIAL ANALYTICS IN R

Emily Riederer

Instructor

DataCamp Financial Analytics in R

Net Present Value (NPV)

Definition: Sum of all discounted cashflows minus (net) the cost of investment Decision Rule: Invest when NPV > 0 Generally prefer projects offering higher NPV Pitfalls: Highly sensitive to the discount rate Ignores project size

DataCamp Financial Analytics in R

Calculating NPV

n <- 0:(length(cashflows) - 1) npv <- sum( calc_pv(cashflows, r, n) ) npv

DataCamp Financial Analytics in R

Internal Rate of Return (IRR)

Definition: The required rate of return (i.e. discount rate) for the investment to break-even. Also known as the hurdle rate. Decision Rule: Invest when IRR > Discount Rate Generally prefer projects offering higher IRR Pitfalls: Doesn't capture magnitude of opportunity Could have zero or multiple IRRs Assumes 100% reinvestment of all cashflows at same rate

DataCamp Financial Analytics in R

Calculating IRR

# assume we have calc_npv function with signature: # calc_npv(cashflows, r) uniroot(calc_npv, interval = c(0, 1), cashflows = cashflows)$root

DataCamp Financial Analytics in R

Profitability Index

Definition: The ratio of the discounted value of all future cashflows divided by the cost of the initial investment Decision Rule: Profitable when profitability index > 1 Generally prefer projects offering higher profitability index Pitfalls: Like IRR, doesn't capture magnitude of opportunity Like NPV, highly reliant on estimated discount rate

DataCamp Financial Analytics in R

Calculating Profitability Index

npv_fcf <- calc_npv(future_cashflow, r) profitability_index <- npv_fcf / abs(initial_investment)

DataCamp Financial Analytics in R

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FINANCIAL ANALYTICS IN R

DataCamp Financial Analytics in R

Terminal Value

FINANCIAL ANALYTICS IN R

Emily Riederer

Instructor

DataCamp Financial Analytics in R

What is terminal value (TV)?

Represents all future cashflows past the end of our forecasting period Hard to measure with great granularity Improper to ignore

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Adding terminal value to the cashflow

DataCamp Financial Analytics in R

Calculating terminal value (TV)

Perpetuity method: Assume constant growth rate of cashflow forever Growth rate must be less than discount rate Effect of growth muted by discounting over time

final_cashflow <- cashflow[n] terminal_value_period_n <- final_cashflow / (discount_rate - growth_rate) terminal_value_as_present <- terminal_value_period_n / (1 + discount_rate)^n

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Other approaches

Exit multiplier method Use benchmark/factor on some key performance metric (e.g sales) Highly dependent on available data

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Let's give it a try!

FINANCIAL ANALYTICS IN R

DataCamp Financial Analytics in R

Comparing & Computing Metrics

FINANCIAL ANALYTICS IN R

Emily Riederer

Instructor

DataCamp Financial Analytics in R

NPV vs. IRR

Equal in unconstrained setting because NPV = 0 <-> IRR = Discount Rate IRR: Discount rate that allows us to break even NPV = 0: Definition of breaking even

DataCamp Financial Analytics in R

NPV vs IRR

Equal in unconstrained setting because NPV = 0 <-> IRR = Discount Rate IRR: Discount rate that allows us to break even NPV = 0: Definition of breaking even Not equal when we have to choose between options NPV answers in $ and size output depends on size input IRR answers in % and lacks context on opportunity size

DataCamp Financial Analytics in R

Scoring Profitability Metrics with group_by() and summarize()

• ption

time cashflow 1

• 100

1 1 50 1 2 200 2

• 300

2 1 60 2 2 500

• ptions

DataCamp Financial Analytics in R

Scoring Profitability Metrics with group_by() and summarize()

• ption

time cf 1

• 100

1 1 50 1 2 200 2

• 300

2 1 60 2 2 500

• ption

npv 1 118 2 184

• ptions
• ptions %>%

group_by(option) %>% summarize(npv=calc_npv(cf,0.08))

DataCamp Financial Analytics in R

Let's practice!

FINANCIAL ANALYTICS IN R

DataCamp Financial Analytics in R

Recap of Metrics

FINANCIAL ANALYTICS IN R

Emily Riederer

Instructor

DataCamp Financial Analytics in R

Metrics Covered

Concepts: Payback Period Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index Functions:

calc_payback() calc_npv() calc_irr() calc_profitability_index()

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Other Metrics

Common Metrics ROE ROA Company Specific

DataCamp Financial Analytics in R

Onto the final chapter!

FINANCIAL ANALYTICS IN R