Basic Finance Skills No MBA Required (RIF001) Tuesday April 28, :00 a.m. - 11:00 a.m.

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2 Basic Finance Skills No MBA Required (RIF001) Tuesday April 28, :00 a.m. - 11:00 a.m. Speakers: Sandra K. Little, Risk Manager, Bar-S Foods Company Jerry L. Stevens, Professor of Finance, University of Richmond Marcia A. Linton, National Analytics Practice Leader, Wells Fargo Insurance Page 2

3 Sandra K. Little, CRM, ARM, CPCU, MBA Manager, Enterprise Risk, Bar-S Foods Co. Sandra K. Little is the Risk Manager for Bar-S Foods Co. a subsidiary of Sigma-Alimentos. Her current responsibilities include developing and implementing an effective Enterprise Risk Management strategy and Crisis Management planning. Additionally, she oversees the Property/ Casualty Insurance program, claims management and litigation in the areas of worker s compensation, automobile, general and product liability. Ms. Little is assisting with further development of the Company consumer affairs strategy, and she coaches and trains in the areas of risk. Prior to joining Bar-S Foods Co. Ms. Little was the Director of Risk Management for Elizabeth Arden Spas Inc., and had previously worked as a liability claims examiner and supervisor. In addition to her job duties, Ms. Little is an occasional online instructor for the ARM program, volunteers at her church and is becoming involved in a local mentoring program. Page 3

4 Jerry L. Stevens, B.S., M.S, Ph.D., CCM Professor of Finance, University of Richmond Jerry L. Stevens is a Professor of Finance and the David Meade White Distinguished Teaching Fellow at the University of Richmond. He received his B.S. from Missouri State University in 1972 and was an officer in the U. S Army from 1972 to He received his M.S. (1977) and Ph.D. (1980) from the University of Illinois. Prior to joining the Robins School in 1987, he was a faculty member at Southern Illinois University and the University of Virginia. While at the University of Richmond he won the Distinguished Educator Award (twice), the Outstanding Teacher Award (three times), Outstanding Service Award (twice), and the Outstanding Advisor Award. He held the Joseph Jennings Endowed Chair for two terms ( ) and currently is the David Meade White Teaching Fellow. Professor Stevens has over 50 publications in both basic and applied research journals to include the American Economic Review; Journal of Portfolio Management; Financial Management; Journal of Accounting, Auditing, and Finance; Financial Services Review; Journal of Investment Consulting; and the Journal of Financial Planning. Professor Stevens is also on the faculty of the National Alliance where he is a speaker for the Certified Risk Management program. Professor Stevens was a founding member of the Vantage Consulting group in 1980 where he is the senior consultant and economist for pension fund accounts. Page 4

5 Marcia Linton, ARM, CRM National Analytics Practice Leader, Wells Fargo Insurance Marcia Linton is a senior vice president and national analytics practice leader for Wells Fargo Insurance. The analytics practice provides analytical consulting for risk management customers. Services include loss forecasting and accrual studies, collateral analysis, risk retention analysis, program comparisons and cash flow modeling, cost of risk allocation, and risk bearing capacity analysis. Linton joined Wells Fargo Insurance in January 2009 when Wells Fargo & Co. acquired Wachovia. She had been affiliated with Wachovia since Her prior experience includes work as a financial analyst for a national broker, and as a commercial loan portfolio manager and assistant branch manager in the commercial banking industry. She has been in financial services since 1988 and in the insurance industry since Linton has been a featured speaker on risk management to a number of groups, including several presentations on Actuarial Reports and Collateral Analysis to the national Risk and Insurance Management Society (RIMS) annual conference. Linton currently serves as a faculty member for the National Alliance Certified Risk Manager Program. Linton has an MBA in risk management and finance from the University of Georgia and a bachelor of science degree in finance from the University of Florida. She holds the Associate in Risk Management (ARM) and the Certified Risk Manager (CRM) designations. Page 5

6 Learning Objectives At the end of this session, you will: be familiar with basic finance skills (present value, future value, discount rates and time value of money); quantify the decision-making process; add practical risk management applications to your repertoire. Time Value of Money Present Value, Discount Rate, Incremental Cash Flow Methods of Evaluating Capital Investment Projects Payback, ARR, IRR, BCR, NPV Applications to a Simple Investment Decision Net Cash Flow Case Study Risk Financing Decision (Compare Program Options); Safety Equipment Investment Page 6

7 Finance in Risk Management Let s talk money Company Financial Objectives What are they? Improve cash flow? Increase revenue? Take advantage of opportunities What risks are involved? Risk Management Departmental Objectives What are my Key Performance Indicators? As an Enterprise Risk Manager, how do I measure success? Application of Finance principles to Enterprise Risk Management Measuring Key Performance Indicators Measuring Capital Investment Projects or other financial opportunities What does it tell us? Page 7

8 Financial Decisions Fair comparisons of benefits and costs requires putting everything in present value (discounting) Discounting requires an interest rate time is money as long as interest rates are positive For a business the interest rate is the cost of capital and all projects use the same rate Page 8

9 Financial Decisions Compounding A dollar today will be worth more than a dollar tomorrow (FV of a $) $100 PV 1 10% FV = $100(1.1) = $110 $100 PV 2 10% per year FV = $100(1.1) 2 = $121 Page 9

10 Financial Decisions Discounting A dollar tomorrow is worth less than a dollar today. PV = $110 / (1.1) = $ % FV = $110 PV= $121/ ( 1.1) 2 = $ % FV = $121 Page 10

11 Financial Decisions Typical Project...estimate future cash flows (CF) relative to initial investment $CF1 $CF2 $CF3... $CFN <$ Initial Investment> Page 11

12 Financial Decisions Present value (discounting) requires a benchmark interest rate (discount rate) Discount rate (%) is based on the cost of raising money. The cost of capital is the weighted average of sources of financing (CFO sets this rate) All projects get same cost of capital unless we adjust for risk differences Page 12

13 Decision Criteria 1. Payback (Years) 2. Accounting Rate of Return (ARR) 3. Net Present Value (NPV) 4. Profitability Index (Present Value Benefit/ Present Value Costs) 5. Internal Rate of Return (IRR) Page 13

14 Decision Criteria 1. Payback Payback amount of time until breakeven Example: How long will it take to get $100,000 back? <$100,000> Investment Benefit: Net After-tax Cash Flow Yr. 1 Yr. 2 Yr. 3 Yr. 4 10,000 40,000 30,000 50,000 90,000 left 50,000 left 20,000 left 20,000/50,000 =.4 Payback = 3.4 years Page 14

15 Pro: Decision Criteria Payback Pro and Con Easy to use and interpret Reflects liquidity (cash back) and minimizes risk of unknown future Con: Doesn t use time value of money (we could adjust for this) Doesn t consider cash flow after payback Bias against growth projects Page 15

16 Criteria for a Good Decision 2. Average Rate of Return Average Rate of Return (ARR) average operating profit over the life of the project divided by the initial investment. Example: Five year investment with straight line depreciation Initial Investment Average Annual Earnings Before Interest, Taxes, and Depreciation (EBITDA) Average Annual Depreciation $100,000 $40,000 $20,000 ARR = ($40,000 - $20,000) / $100,000 = 20% Page 16

17 Decision Criteria Average Rate of Return (ARR) Pro and Con Pro: Con: Simple to use This is a crude rate of return estimate Doesn t use time value of money Doesn t use cash flow and adjustments for non-cash charges or taxes Doesn t have a good benchmark for comparisons Page 17

18 Decision Criteria 3. Net Present Value Net Present Value (NPV) Present value of benefits minus present value of costs. NPV must be positive for a good decision. Example: Initial investment of $100,000 generates four years of estimated cash flows. Discount rate is assumed to be 10%. Good decision? Yr. 1 Yr. 2 Yr. 3 Yr. 4 Investment <$100,000> Benefit: Net Cash Flow $10,000 $40,000 $30,000 $50,000 Page 18

19 Decision Criteria Net Present Value Example Find the Present Value of Future Cash Flows using a 10% discount rate and subtract Present Value of Costs Yr. 1 Yr. 2 Yr. 3 Yr. 4 Investment <$100,000> Benefit: Net Cash Flow $10,000 $40,000 $30,000 $50,000 Discount 10% Present Value Cash Flow $9,091 $33,056 $22,539 $34,150 Total $98, NPV = $98, $100,000 = -$1,164 Not a good investment Page 19

20 Pro: Decision Criteria Net Present Value (NPV) Pro and Con NPV uses time value of money NPV uses the cost of capital (assumes reinvestment is at the firm s cost of capital) NPV is in dollars and is easy to interpret Con: If there is capital rationing or mutually exclusive projects the size of the investment must be taken into account. We need a benefit per dollar spent measure. Page 20

21 Decision Criteria 4. Internal Rate of Return PV Costs = CF 1 /(1+IRR) 1 +CF 2 / (1+IRR) CF N / (1+IRR) N Solve for IRR...use a computer or calculator The IRR > Cost of Capital for a good project Page 21

22 Decision Criteria Internal Rate of Return Example Example: Use Data from the NPV Calculation Yr. 1 Yr. 2 Yr. 3 Yr. 4 Investment Cost <$100,000> Benefit: Net Cash Flow $10,000 $40,000 $30,000 $50, ,000 = 10,000 / (1+X) + 40,000 / (1+X) ,000 / (1+X) ,000 / (1+X) 4 Solve for X =.0955 = 9.55% = IRR IRR < 10% Cost of Capital Not a good investment Page 22

23 Decision Criteria Internal Rate of Return Pro and Con Pro: Easy to interpret people like % comparisons Con: Difficult to calculate without a computer/calculator Assumes cash flows can be reinvested at the same IRR unrealistic Multiple IRRs occur if cash flows change signs. Page 23

24 Decision Criteria 5. Profitability Index (benefit-cost ratio) Profitability Index = Benefit-to-Cost Ratio = the ratio of the present value of benefits to the present value of costs. A ratio greater than one is acceptable (Benefits>Costs). If the benefit-to-cost ratio is one the NPV = 0. The benefit to cost ratio offers a bang for the buck measure Page 24

25 Decision Criteria Profitability Index - Example Example: Use the same data we used for the NPV Calculation Yr. 1 Yr. 2 Yr. 3 Yr. 4 Investment < $100,000> Benefit: Net $10,000 $40,000 $30,000 $50,000 Cash Flow Discount % Present Value $9,091 $33,056 $22,539 $34,150 Total PV $98, Profitability Index = $98,836 / $100,000 =.98936< 1 Not a good project Page 25

26 Decision Criteria Profitability Index Pro and Con Pro: Profitability Index is the preferred method for choosing between mutually exclusive projects and for capital rationing... biggest bang for the buck. Con: Dollar amounts reveal dollar value added while ratios do not offer information on magnitudes. Page 26

27 Incremental Costs and Benefits Key Points Incremental costs and benefits added costs and benefits beyond what would have they would have been without the decision or investment. Sunk Costs costs paid whether the project is taken or not. Sunk costs are irrelevant to the decision and are not included in costs. Opportunity costs - imputed costs for assets that are already owned but have alternative uses. Opportunity costs are included in cash flows. Page 27

28 Incremental Costs and Benefits Key Points Purchase of depreciable assets up-front costs for long-term assets are included in the initial cost but a depreciation schedule is used to calculate depreciation for tax purposes. We deduct depreciation from beforetax income but add it back to get net cash flow. Financing Costs costs of financing are not included in the cash flows. The financing cost is captured in the firm s discount rate (cost of capital) used in the time value calculations. Page 28

29 Incremental Costs and Benefits Key Points Benefits can occur either from increased revenues or from lower costs. Lowering costs is more likely in risk management. A $ saved is a $ earned. Likely benefits for risk managers include the following. o reduced premiums o reduction in loss payments o tax reductions Page 29

30 Comprehensive Example Saxon Healthcare Mini-Case Overview - This mini-case first illustrates the construction of costs and benefits from an investment in loss control. Next, the decision criteria are calculated and applied to support a decision. Jane, the risk manager of Saxon Healthcare Inc. is considering installation of a new generation software system that provides state-of-the art processing of patient information, medical records, and patient billing. The new system requires investment in a new software, new hardware, and employee training. Page 30

31 Comprehensive Example Saxon paid $10,000 to a consulting firm for a feasibility study and cost estimates. The new software and hardware for the system will cost $200,000 to include installation. Another $30,000 will be required for initial training. The new system has a four year life for depreciation purposes with no salvage value. Jane will use straight line depreciation for the system. There will be some information technology maintenance involved but Saxon has a skilled IT staff that can perform this job. Currently, the IT staff works for $40 per hour and there will be a projected 100 hours per year of maintenance linked to the new system. Page 31

32 Comprehensive Example Saxon is a for-profit organization and the appropriate tax rate is 34%. Jane doesn t think there is any salvage value for existing software or hardware systems that are to be replaced. The existing hardware has already been fully depreciated. Consultants estimate that the new system will lower errors and omissions by 15% per year. Jane s carrier has some experience with other healthcare providers using the new system and quoted a reduction in premiums of $100,000 per year over the next four years if the experience rating is in line with the expected reduction in errors and omissions. Page 32

33 Comprehensive Example Jane knows the CFO has a 10% cost of capital requirement for capital budgeting projects like hers. She has to formulate her analysis and decide whether or not to bring it to the capital budgeting committee for approval. Jane wants to consider a wide range of decision criteria to support her analysis. She wants to construct the payback, ARR, NPV, IRR and Benefit to Cost Ratio. Page 33

34 Comprehensive Example Jane s Worksheet Depreciation Schedule: $200,000 over 4 years = $50,000 per year Page 34

35 Comprehensive Example Jane s Worksheet Year 1 Year 2 Year 3 Year 4 Premium Reduction $100,000 $100,000 $100,000 $100,000 IT Staff Costs -$4,000 -$4,000 -$4,000 -$4,000 Increase in Operating $96,000 $96,000 $96,000 $96,000 Income Depreciation Deduction -$50,000 -$50,000 -$50,000 -$50,000 Taxable Income $46,000 $46,000 $46,000 $46,000 34%. -$15,640 -$15,640 -$15,640 -$15,640 Incremental Income $30,360 $30,360 $30,360 $30,360 Depreciation +$50,000 +$50,000 +$50,000 +$50,000 After Tax Incremental CF $80,360 $80,360 $80,360 $80,360 PV factor A 10% PV After Tax Incremental CF* $73,055 $66,410 $60,374 $54,886 Page 35

36 Comprehensive Example Jane s Worksheet-Payback After Tax Incremental CF $80,360 $80,360 $80,360 $80,360 Year 1: $230,000 - $80,360 = $149,640 Year 2: $149,640 - $80,360 = $69,280 Year 3: $69,280 /$80,360 =.8621 Payback = Years Page 36

37 Comprehensive Example Jane s Worksheet - ARR Increase in Operating Income $96,000 $96,000 $96,000 $96,000 ARR = Average Annual EBITDA / $230,000 = $96,000/230,000 ARR = 41.74% WOW! Page 37

38 Comprehensive Example Jane s Worksheet - NPV After Tax Incremental CF $80,360 $80,360 $80,360 $80,360 PV factor A 10% PV After Tax Incremental CF* $73,055 $66,410 $60,374 $54,886 73, , , ,886 = $254,725 PV of Incremental CF = $254,725 NPV = $254,725 - $230,000 = $24,725 Page 38

39 Comprehensive Example Jane s Worksheet Benefit / Cost Ratio After Tax Incremental CF $80,360 $80,360 $80,360 $80,360 PV factor A 10% PV After Tax Incremental CF* $73,055 $66,410 $60,374 $54,886 73, , , ,886 = $254,725 PV of Incremental CF = $254,725 Benefit Cost Ratio = 254,725 / 230,000 = Page 39

40 Comprehensive Example Jane s Worksheet IRR After-Tax Incremental CF $80,360 $80,360 $80,360 $80,360 80,360 / (1+X) + 80,360 / (1+X) ,360/ (1+X) ,360/(1+X) 4 = $230,000 X = IRR = % Page 40

41 Comprehensive Example Jane s Worksheet Benefit / Cost Ratio After Tax Incremental CF $80,360 $80,360 $80,360 $80,360 PV 10% PV After Tax Incremental CF* $73,055 $66,410 $60,374 $54,886 73, , , ,886 = $254,725 PV of Incremental CF = $254,725 Benefit Cost Ratio = 254,725 / 230,000 = Page 41

42 Case Study 1 Risk Financing Options You are given 2 risk financing options: $250,000 large deductible program and a Guaranteed Cost Option. How do you decide which is the best option? First step is to calculate the Net Present Value Cost of both options Consider appetite for risk Include all incremental cash flows of each option Letter of Credit Charges Claims Handling Fees Loss Control Charges Page 42

43 Case Study 1 Risk Financing Options Assumptions: Program Options Option I $250,000 Deductible Option II Guaranteed Cost Premium $ 1,500,000 $ 2,300,000 Payment plan 12 equals 12 equals Retained Losses (Loss Pick) $ 800,000 NA Total Loss Pick $ 2,300,000 $ 2,300,000 Discount Rate = 6% (Annual) Assume premiums paid immediately (beginning of month) Assume losses paid at end of month Page 43

44 Case Study 1 Risk Financing Options Payout Factors: Month Paid LDF 1/ldf Payout factor % % % % % % For this example, we are only looking at premiums plus losses (Not including claims handling fees, assessments, loss control, letter of credit fees, etc ) Page 44

45 Case Study 1 Risk Financing Options Option I - $250,000 Deductible: NPV of Premium (Step 1) Payments are at beginning of month 1 st month n = 0 i= 6%/12 i=.5% Month Premium n= PV Factor PV of Premium 1 $ 125, $ 125,000 2 $ 125, $ 124,378 3 $ 125, $ 123,759 4 $ 125, $ 123,144 5 $ 125, $ 122,531 6 $ 125, $ 121,921 7 $ 125, $ 121,315 8 $ 125, $ 120,711 9 $ 125, $ 120, $ 125, $ 119, $ 125, $ 118, $ 125, $ 118,327 Total Premium Year 1 $ 1,500,000 $ 1,459,628 Monthly premium = $1.5M/12 PV Factor n=1, i=.5% =.9950 *Note: numbers calculated in excel spreadsheet will be slightly different than calculator due to rounding Page 45

46 Case Study 1 Risk Financing Options Option I - $250,000 Deductible: Or Use Annuity Table Shortcut: Payments are at beginning of month Month Premium PV Annuity Factor PV of Premium First Payment 125, ,000 Next 11 Payments (n=11, i=.5%) 125, ,334,628 Total Premium Year 1 $ 1,459,628 PV Annuity Factor n=11, i=.5% = Monthly premium = $1.5M/12 *Note: numbers calculated in excel spreadsheet will be slightly different than calculator due to rounding Page 46

47 Case Study 1 Risk Financing Options Option I - $250,000 Deductible: NPV of Paid Losses (Step 2) Total Loss x Payout Factor i=6% Year Cumulative Payout % Cumulative Losses Paid Incremental Paid Losses PV Factor PV Cost of Paid Losses 1 21% $ 166,736 $ 166, $ 157, % $ 363,141 $ 196, $ 174, % $ 473,373 $ 110, $ 92, % $ 540,176 $ 66, $ 52, % $ 640,000 $ 99, $ 74, % $ 800,000 $ 160, $ 112,794 Total Loss Payments Total $ 800,000 $ 800,000 $ 664,953 PV Factor n=1, i=6% =.9434 $363,141- $166,736 = $196,405 Losses paid end of year *Note: numbers calculated in excel spreadsheet will be slightly different than calculator due to rounding Page 47

48 Case Study 1 Risk Financing Options Option I - $250,000 Deductible: NPV Total Cost of Deductible Option Step 1 NPV Cost of Deductible Premium = $1,459,628 Step 2 NPV Cost of Retained Losses = $ 664,953 Total NPV Cost $2,124,581 *Note: numbers calculated in excel spreadsheet will be slightly different than calculator due to rounding Page 48

49 Case Study 1 Risk Financing Options Option II Guaranteed Cost: NPV of Premium Payments are at beginning of month 1 st month n = 0 i= 6%/12 i=.5% Month Premium n= PV Factor PV of Premium 1 $ 191, $ 191,667 2 $ 191, $ 190,713 3 $ 191, $ 189,764 4 $ 191, $ 188,820 5 $ 191, $ 187,881 6 $ 191, $ 186,946 7 $ 191, $ 186,016 8 $ 191, $ 185,091 9 $ 191, $ 184, $ 191, $ 183, $ 191, $ 182, $ 191, $ 181,435 Total Premium Year 1 $ 2,300,000 $ 2,238,097 PV Factor n=1, i=.5% =.9950 Monthly premium = $2.3M/12 *Note: numbers calculated in excel spreadsheet will be slightly different than calculator due to rounding Page 49

50 Case Study 1 Risk Financing Options Option II Guaranteed Cost: Or Use Annuity Table Shortcut: Payments are at beginning of month Month Premium PV Annuity Factor PV of Premium First Payment 191, ,667 Next 11 Payments (n=11, i=.5%) 191, ,046,430 Total Premium Year 1 $ 2,238,097 PV Annuity Factor n=11, i=.5% = Monthly premium = $2.3M/12 *Note: numbers calculated in excel spreadsheet will be slightly different than calculator due to rounding Page 50

51 Case Study 1 Risk Financing Options NPV Results Program Options Option I $250,000 Deductible Option II Guaranteed Cost Premium $ 1,500,000 $ 2,300,000 Payment plan 12 equals 12 equals Retained Losses (Loss Pick) $ 800,000 NA Total Loss Pick $ 2,300,000 $ 2,300,000 Option I Deductible NPV Cost: $2,124,581 Option II Guaranteed Cost NPV Cost: $2,238,097 Which option would you choose and why? Page 51

52 Case Study 1 Risk Financing Options Option I Deductible NPV Cost: $2,124,581 Option II Guaranteed Cost NPV Cost: $2,238,097 Option I Deductible: Lower NPV cost Potential for lower cost if control losses Higher risk if losses worse than expected Will have to post collateral which was not taken into consideration Option II Guaranteed Cost: Higher NPV Cost Certain payment/less risk Less control of losses Page 52

53 Case Study 2 Safety Equipment Purchase ABC Home Improvement Store is considering the purchase of forklifts to help workers safely stock store shelves Cost of this equipment is $800,000 and the useful life of equipment is 5 years Projected annual reduction in Workers Compensation annual losses is $275,000 resulting in an estimated annual premium reduction of $200,000 Premiums paid beginning of year Discount rate is 6% Tax Rate is 40% Equipment will be purchased this year (n=0) Page 53

54 Case Study 2 Safety Equipment Purchase Step 1: Calculate the Before Tax Discounted Premium Savings =2x3 Before Tax Total i=6% Discounted Premium Premium Year Savings Discount Rate) Savings 2015 (n=0) $ 200,000 $ 200, (n=1) $ 200, $ 188, (n=2) $ 200, $ 177, (n=3) $ 200, $ 167, (n=4) $ 200, $ 158,419 Total $ 1,000,000 $ 893,021 (Can also use annuity table) PV Factor n=1, i=6% =.9434 Page 54

55 Case Study 2 Safety Equipment Purchase Step 2: Calculate the After Tax Discounted Premium Savings =2x3 5=4xt 6=4-5 i=6% Before Tax After Tax Total Discounted Discounted Year Premium Savings Discount Rate) Premium Savings Tax (40%) Premium Savings 2015 (n=0) $ 200,000 $ 200, (n=1) $ 200, $ 188, (n=2) $ 200, $ 177, (n=3) $ 200, $ 167, (n=4) $ 200, $ 158,419 Total $ 1,000,000 $ 893, ,208 $ 535,813 40% x $893,021 $893,021 - $357,208 = $535,813 Page 55

56 Case Study 2 Safety Equipment Purchase Step 3: Calculate Annual Depreciation Machine Cost $ 800,000 Useful Live 5 Cost Per Year $ 160,000 $800K/5 Tax Rate 40% Tax Savings Per Year $ 64,000 40% x $160,000 Step 4: Calculate Annual Depreciation Tax Benefit Year Tax Benefit Discount Rate) Discounted Depreciation Tax Benefit 2015 (n=0) $ 64,000 $ 64, (n=1) $ 64, $ 60, (n=2) $ 64, $ 56, (n=3) $ 64, $ 53, (n=4) $ 64, $ 50,694 Total $ 320,000 $ 285,767 (Can also use annuity table) Page 56

57 Total 6% Case Study 2 Safety Equipment Purchase Cost of Machine $ (800,000) AT Discounted Premium Savings (Step 2) $ 535,813 Discounted Depreciation Tax Benefit (Step 4) $ 285,767 After Tax NPV $ 21,579 NPV is greater than $0, therefore purchase the equipment Page 57

58 Case Study 2 Safety Equipment Purchase NPV analysis is dependent on your assumptions What would happen if we raised the discount rate from 6% to 8%? Step 1 & 2 : Calculate the After Tax Discounted Premium Savings =2x3 5=4xt 6=4-5 Year Total Premium Savings i=8% Discount Rate) Before Tax Discounted Premium Savings Tax (40%) After Tax Discounted Premium Savings 2015 (n=0) $ 200,000 $ 200, (n=1) $ 200, $ 185, (n=2) $ 200, $ 171, (n=3) $ 200, $ 158, (n=4) $ 200, $ 147,006 Total $ 1,000,000 $ 862, ,970 $ 517,455 Page 58

59 Case Study 2 Safety Equipment Purchase Step 3: Calculate Annual Depreciation Machine Cost $ 800,000 Useful Live 5 Cost Per Year $ 160,000 $800K/5 Tax Rate 40% Tax Savings Per Year $ 64,000 40% x $160,000 Step 4: Calculate Annual Depreciation Tax Benefit i=8% Discounted Depreciation Year Tax Benefit Discount Rate) Tax Benefit 2015 (n=0) $ 64,000 $ 64, (n=1) $ 64, $ 59, (n=2) $ 64, $ 54, (n=3) $ 64, $ 50, (n=4) $ 64, $ 47,042 Total $ 320,000 $ 275,976 Page 59

60 Case Study 2 Safety Equipment Purchase Total 8% discount rate Cost of Machine $ (800,000) AT Discounted Premium Savings (Step 3) $ 517,455 Discounted Depreciation Tax Benefit (Step 6) $ 275,976 After Tax NPV $ (6,569) NPV is less than $0, therefore do not purchase the equipment Page 60

61 Case Study 2 Safety Equipment Purchase Total 6% discount rate Cost of Machine $ (800,000) AT Discounted Premium Savings (Step 2) $ 535,813 Discounted Depreciation Tax Benefit (Step 4) $ 285,767 After Tax NPV $ 21,579 Total 8% discount rate Cost of Machine $ (800,000) AT Discounted Premium Savings (Step 2) $ 517,455 Discounted Depreciation Tax Benefit (Step 4) $ 275,976 After Tax NPV $ (6,569) The higher the discount rate, the lower the NPV It is more difficult to get projects approved at higher discount rates Page 61

62 Learning Objectives At the end of this session, you will: be familiar with basic finance skills (present value, future value, discount rates and time value of money); quantify the decision-making process; add practical risk management applications to your repertoire. Time Value of Money Present Value, Discount Rate, Incremental Cash Flow Methods of Evaluating Capital Investment Projects Payback, ARR, IRR, BCR, NPV Applications to a Simple Investment Decision Net Cash Flow Case Study Risk Financing Decision (Compare Program Options); Safety Equipment Investment Page 62

63 Basic Finance Skills No MBA Required Questions? Page 63