INVESTMENT DECISIONS: STATIC METHODS
The investment Decision Process
The investment decision process involves three basic steps:
Generating investment proposals: to have more options to invest in.
Reviewing, analyzing, and selecting from the proposals that have been granted (take this proposals, and choose the one which maximize the shareholders' value).
Implementing and monitoring the investment proposals that have been selected.
Managers should separate investment (their own financing) and financing decisions (to acquire profit).
There are 2 main kind of investments:
Real investment: money invested in tangible and productive assets such as the company's production plant or machinery.
Financial Investment: Purchase of an asset or item with the hope that it will generate a financial income (ex; dividends), or that its value will increase in the future, so that it can be sold at a higher price (company expects to have profits out of it).
Elements in the Investment Decision Process:
Initial Investment required (initial payment, or initial outlay) to start the project. - To get from the initial idea until the launch of the company.
Duration of the investment, in terms of deadlines. - Refers to the duration of the investment project (the time).
Collections and payments of the project. - The net cash flows = difference between the inputs and outputs of the project life.
Two important things to take into account when doing an investment:
Initial investment - Amount of funds that the company / entrepreneur needs to start the project. - Includes the cost of: 1. Necessary assets to start the busines (ex. machine). 2. Other various concepts necessary to implement the project (ex. fuel). - Considered as a net outflow (money going out) in time 0: 1. Calculated as the updated sum of all initial payments - Initial Outlay = Initial Investment in Fixed Assets* + Cash needed to start operations.
Time Horizon - Time from the first project payment until the last investment return that is generated. - It is necessary to limit the period examined in order to perform the calculations. - It is important for the calculation because we need to have some idea of how much it takes from the first payment until the last cash action.
* "A fixed asset is a long-term tangible piece of property or equipment that a firm owns and uses in its operations to generate income. Fixed assets are not expected to
be consumed or converted into cash within a year. Fixed assets most commonly appear on the balance sheet asproperty, plant, and equipment(PP&E). They are also referred to ascapital assets" (Investopedia, 2020)
Investment decisions: Static method
In static methods there is one thing that they do NOT consider which is the fact tha the value of money in time is different.
An investment decision should take into account, to select the best investment projects, the following criteria:
Account for the time value of money
Account for risk - Measure the risk of each project.
Focus on cash flows - Sometimes we lose side of what cash flows are. The cash flow report is important because it informs the reader of the business cash position. For a business to be successful, it must have sufficient cash at all times. It needs cash to pay its expenses, to pay bank loans, to pay taxes and to purchase new assets.
Rank competing projects appropriately - Classify the projects from the best one to the worst one.
Lead to investment decisions that maximize shareholders' wealth - Choose the ones that maximize shareholders' value.
Example: From this two different investment which one do you consider that is the best one?
Investment 1
Initial Outlay = -$450 In investment 1, if we sum up Year 1+2+3 = 70 + 160 + 220 Year 1 inflow = $70 it is equal to $450, which means that we have recovered
Year 2 inflow = $160 the initial outlay of $450 in 3 years.
Year 3 inflow = $220
Year 4 inflow = $320
Year 5 inflow = $350
Investment 2
Initial Outlay = -$100 In investment 2, if we sum up Year 1+2 = 25 + 75
Year 1 inflow = $25 it is equal to $100, which means that we have recovered
Year 2 inflow = $75 the initial outlay of $100 in 2 years.
Year 3 inflow = $103
Year 4 inflow = $125
Year 5 inflow = $135
So, taking into account that investment 1 recovers its initial payment in 3 years, and investment 2 recovers its initial payment in 2 years, which is the best option? Investment 1, or 2? Answer: The best option and, therefore, the project that we have to accept is the one of investment 2, because it takes less time to recover the total amount of the initial payment.
There are 3 Statistic Methods:
Payback period: How much time does the company need to recover the investment. Companies have to establish how long they are able to recover this money. Management determines the maximum acceptable payback period. - If the project's payback period is less than the maximum acceptable payback period, accept the project. - If the project's payback period is greater than the maximum acceptable payback period, reject the project. Advantages: - Easy to calculate - Easy to understand - Focuses on cash flow Disadvantages: - It does not take into account the time value of money - It does not measure risk - Cutoff period is arbitrary (Ex: 2.75 years is not the optimal period, the company decides which is the optimal period) - And, this arbitrary decision does not lead to value maximizing decisions
Cash Flow Profitability Method: it consists of calculating the cash flow pero € invested. - Formula: r = Sum of Cashflows / |Initial investment| * The initial investment must be positive when dividing, that's why the initial investment is considered as an absolute value and is between two lines = |Initial investment| and is the negative number established in year 0. - If the project's cash flow profitability is bigger than 1, then we accept the project. - The bigger cash flow profitability, the better. Advantages: - Easy to calculate - Easy to understand - Focuses on cash flow Disadvantages: - It does not take into account the time value of money - It does not measure risk - Profitability refers to an annual rate, but cash flow profitability is the accrued profitability in the life of the project (adds all the years at the same level instead of an average)
Average Annual Cash Flow Profitability Method - In this case, we calculate the average annual cash flow per € invested - Formula: r = (Sum of CashFlows / n) / |Initial investment| * where n = years and Initial investment, the negative number established in year 0, which must be turned into positive as in the case of the Cash Flow Probability method. - The bigger, the better and the one accepted. Advantages: - Easy to calculate - Easy to understand - Focuses on cash flow - Annual basis Disadvantages: - It does not take into account the time value of money - It does not measure risk
I created one example (in a google excel sheet) of each method (Payback, CF Profitability and Average Annual CFP).
In the following link you will able to see it:
https://docs.google.com/spreadsheets/d/1J5DfEJwlfaGKw-FyViCpX89en4u54IV4cmZCqQgW4-U/edit?usp=sharing
*This excel sheet will just allow you to see the exercises, you won't be able to modify, or comment.
If you have any question, or doubt, do not hesitate to let a comment in this webpage!!
Thank you!
*The information was gathered from Tecnocampus' slides and own notes. Excel examples are done by myself.
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