ECONOMIC ANALYSIS CONCEPTS

All project economic analysis should be performed based on the following concepts: Net cash flow to energy inc. The cash flow from investment proposals must be analyzed on a comparable basis in order to determine which proposals have the greatest economic value to Energy Inc. Therefore all investments should be evaluated on the basis of after-tax U.S. Dollar cash flow to Energy Inc. A project's cash flow should include all foreign tax effects, such as income and remittance taxes, and any U.S. Income tax effects.

Weighted average cost of capital (WACC) This is the rate used to discount future project net cash flow. The cost of capital is the weighted average after-tax cost of debt, preferred and common stock in Energy Inc.s capital structure. The WACC is calculated by the finance department and issued by the comptroller.

ECONOMIC ANALYSIS CONCEPTS

Current dollar basis.

All cash flow should be stated in current (nominal) dollars (i.e. actual amounts which are expected to be expended or received each year). Current dollar forecasts represent changes due to inflation and any real price change above or below inflation. The rates used should be consistent with the most recent forecast provided by corporate. Foreign currency exchange rates. Forecasted cash flows based on local currencies should be converted into U.S. Dollars using current currency exchange rates.

ECONOMIC ANALYSIS CONCEPTS

Full cycle or full life economics. Economic value of an asset that was acquired in the past and had its value enhanced through additional investments. Results do not represent the current economic value to the firm since the analysis includes prior investment, revenue and expenses. Results include the benefit of hindsight and are useful to improve decisions made in the future.

ECONOMIC MEASURES

The following four measures are commonly used in project analysis. Each one provides important information on the attractiveness of a project. Net Present Value (NPV) Present Worth Payout (PWP) Discounted Cash Flow Return on Investment (DCFROI or IRR) Present Worth Index (PWI)

ECONOMIC MEASURES

Net Present Value (NPV)

The net present value is the economic value expected to be generated by the project at the time of measurement. It represents the value being added to the Company by making the investment. Decision Rule NPV>0 Limitations
A larger investment will normally have a larger present value. A ranking based simply on net present value would therefore tend to favor large investments over small investments. Does not consider length of time to achieve that value.

ECONOMIC MEASURES

Present worth index (PWI)

PWI measures the relative attractiveness of projects per dollar of investment. The ratio of the present value of cash inflows to the present value of the cash outflows. Designed to address the limitation of NPV cited above . Limitations.
It is not a good indicator of the significance of a project. Is dependent on cost of capital used. If cost of capital is over or underestimated could result in selection of wrong project.

ECONOMIC MEASURES

Present worth payout (PWP)

payout measures the time that the net investment will be at risk. The longer the payout period, the more chance for some unfavorable circumstance to occur. Limitation:
Disregards cash flows received after the payout period. It does not directly measure the value created by the project. Is dependent on cost of capital used.

ECONOMIC MEASURES

Discounted cash flow return on investment (DCFROI/IRR).

Measures the efficiency of the project in producing value without reference to any predetermined cost of capital. The discount rate which equates the project's discounted net cash inflows with its discounted net cash outflows.

Decision rule IRR>Cost of capital.

Limitation:
Favors projects with a quick payout or short-term in nature.

FUNDAMENTAL ANALYSIS

FRAMEWORK OF ANALYSIS

Fundamental Analysis Approach to Fundamental Analysis

Domestic and global economic analysis Industry analysis Company analysis

Why use the top-down approach

FINANCE AND GROWTH

SHOCKS TO FINANCE AND GROWTH

Shock to stock market

Shock to macroeconomy

Stock Market

Macroeconomy

Shock to both stock market and macroeconomy

GLOBAL ECONOMIC CONSIDERATIONS

Performance in countries and regions is highly variable Political risk Exchange rate risk
Sales Profits Stock returns

KEY ECONOMIC VARIABLES

Gross domestic product Unemployment rates Interest rates & inflation Budget Deficits Consumer sentiment

DETERMINATION OF THE EQUILIBRIUM REAL RATE OF INTEREST

FEDERAL GOVERNMENT POLICY

Fiscal Policy - government spending and taxing actions

Direct policy Slowly implemented

FEDERAL GOVERNMENT POLICY (CONT.)

Monetary Policy - manipulation of the money supply to influence economic activity

Initial & feedback effects

Tools of monetary policy

Open market operations( federal funds rate) Discount rate Reserve requirements

DEMAND SHOCKS

Demand shock - an event that affects demand for goods and services in the economy
Tax rate cut Increases in government spending

SUPPLY SHOCKS

Supply shock - an event that influences production capacity or production costs

Commodity price changes Educational level of economic participants

BUSINESS CYCLES

Business Cycle
Peak Trough

Industry relationship to business cycles

Cyclical Defensive

NBER CYCLICAL INDICATORS: LEADING

Leading Indicators - tend to rise and fall in advance of the economy Examples
Avg. weekly hours of production workers Stock Prices Initial claims for unemployment Manufacturers new orders

NBER CYCLICAL INDICATORS: COINCIDENT

Coincident Indicators - indicators that tend to change directly with the economy Examples
Industrial production Manufacturing and trade sales

NBER CYCLICAL INDICATORS: LAGGING

Lagging Indicators - indicators that tend to follow the lag economic performance Examples
Ratio of trade inventories to sales Ratio of consumer installment credit outstanding to personal income

INDUSTRY ANALYSIS

Sensitivity to business cycles Sector Rotation Industry life cycles

ESTIMATES OF EARNINGS GROWTH RATES IN SEVERAL INDUSTRIES, 2004

SENSITIVITY TO BUSINESS CYCLE

Factors affecting sensitivity of earnings to business cycles

Sensitivity of sales of the firms product to the business cycles Operating leverage Financial leverage

A STYLIZED DEPICTION OF THE BUSINESS CYCLE

FIGURE 17.6 RETURNS ON EQUITY, 2005

FIGURE 17.7 RATE OF RETURN, 2005

SECTOR ROTATION

Selecting Industries in line with the stage of the business cycle Peak natural resource firms Contraction defensive firms Trough equipment, transportation and construction firms Expanding cyclical industries

SECTOR ROTATION GAINS

HISTORICAL SECTOR PERFORMANCE

Total returns on a representative group of Fidelity Select funds from 1999 to 2003 (fund with highest return for the year in blue).

Yr
1999 2000 2001 2002 2003

Biotech
77.8% 32.8% -25.0% -40.5% 32.9%

Finance
30.6% 28.3% -9.2% -17.2% 36.5%

Const.

Media

Gas

Tech

Wilshire

12.5% 44.1% 26.2% 132.4% 23.6% 8.8% -23.1% 71.0% -31.8% -10.9% 20.0% -1.0% -22.9% -31.7% -11.0% -8.5% -12.8% -9.6% -37.8% -20.9% 44.1% 43.9% 28.7% 59.4% 31.6%

INDUSTRY LIFE CYCLES

Stage Start-up Consolidation Maturity Relative Decline

Sales Growth Rapid & Increasing Stable Slowing Minimal or Negative

THE INDUSTRY LIFE CYCLE