Chapter 4. Investment analysis methods Summar (2016)
Resumen InglésUniversidad  Universidad de Barcelona (UB) 
Grado  Empresa internacional  3º curso 
Asignatura  Finances II 
Año del apunte  2016 
Páginas  11 
Fecha de subida  15/03/2016 
Descargas  14 
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TOPIC 4: INVESTMENT IN A COMPANY,
ANALYSIS METHODS
1. Concept and characteristic of an investment project
Investment: implies a renunciation of a certain and immediate satisfaction in the beginning of
the process in exchange for the hope of a greater future benefit.
Each investment project is composed of the following elements:
The person/entity that makes an investment: the investor
The object of investment: can be: a project, partial/full company,…
Funds (costs) sacrificed at the beginning // Costs arising from a renunciation (foregoing
“cost of opportunity”) of present satisfaction
The expected returns // hope of a greater future benefit
Why and when do firms make an investment?
Major investment decisions (longterm, real asset) of strategic nature are often referred to a
capital budgeting or capital expenditure decisions (CAPEX).
Real investment/Financial investment: first we need financial investment and once we
have the money, a real investment is done.
Fixed assets’ investment/current assets’ investment
Planned investment/nonplanned investment
Strategic investments in long term fixed assets
∆ Risk ∆ Profitability
Stages of an investment project
1. Creation of idea/Initial approach
2. Justification of demand, market studies: compare the opportunity to different
alternatives; justify why we want to carry out this project and not another alternative
3. Study of economic and financial viability
4. The analysis of financing: decision about how to finance
5. Final decision: go or not with the project.
2. Methodology of investment analysis
Things to consider among different alternatives:

Cash movement: amount that will be spent and generated by the project
Dimension: to know whether I am able to face or not this project
Timing
Creation of Cash Flows
Net Cash Flow is the most important thing, we will take it into account.
The Diagram of Cash Flows
For the analysis of the investment project, we need to identify:

When and how much cash we will receive (Rt)
When and how much cash we will pay (Pt)
And the differences between them called Cash Flow (Ct)
Methods of Investment analysis
Static methods: approximate methods that disregard the time dimension and do not
adjust the value of cash flows (methods that do not take into account the time value of
cash flows). Basically based on the balance sheet. Principal disadvantage: it considers
that 1€ today is the same as 1€ tomorrow.
From static to dynamic method: DISCOUNTED PAYBACK: Payback within a dynamic
dimension
Dynamic methods: methods that take into account the changing value of cash flows
over time.
3. Static selection methods of an investment project
These methods are approximate, that disregard the time dimension and do not adjust the
value of cash flows. Methods that do not take into account the time value of cash flows. They
are just complementary.
a) Net Cash Flow by M.U. committed
It is a sum of all cash flows (expected) of each
investment divided by the total of initial
investment.
Disadvantages:
We are adding up heterogeneous(in terms of time value) quantities
The usual way to represent it is subtracting 1.
The result reflects aggregated profitability. It refers to the
entire life of an investment project, so we don’t have the
profitability per year.
b) Average Net Cash Flow by M.U.
committed
This is a ratio between average cash flow,
starting from the moment one, and initial
investment.
Disadvantages:
It doesn’t take into account the changing values of cash flows over time
It is very sensitive to extreme values of cash flows
The positive thing is that it refers to one year as a period of time, rather than to the
entire life of an investment. So it is more easily comparable to other methods.
c) Payback
The length of time taken to recover the initial investment.
A project’s payback period is found by counting the number of years, months, days it takes
before the cumulative cash flow equals the initial investment.
*Rule: a project should be accepted if its payback period is less than some specified cutoff
period.
Advantages:
Useful under conditions of stability: in unstable situations, works worse
Useful for short term decision making
Easy to apply and to understand
Is the simplest way to communicate an idea of project liquidity.
Disadvantages:
Little scientific consistency because it’s adding heterogeneous quantities on the time
ignoring different due date of cash flows.
The payback rule doesn’t take into account the cash flows after the cutoff date, and
doesn’t give any reference to total profitability of the projects
Liquidity criterion cares more than profitability: the time of reinvorsement more
important than the difference between the initial and final situation.
Example 1: Payback limitation
Considering the time value of money (which doesn’t do the payback method) the two amounts
of 3.000€ are not the same, since they are given in different points of time. Anyway, the
payback method considers both the same.
Based on the payback criterion, we would choose A because it is the first that recovers the
investment, even though B is more profitable.
Example 2: Summarizing static methods
r’: Net cash flow
/r’: average net cash flow
4. From Static to Dynamic methods: the discounted payback
“Intermediate method”
It offsets the payback method weak point:
Little scientific consistency because it’s adding heterogeneous quantities on the time
ignoring different due date of cash flows.
But remains:
The payback rule doesn’t take into account the cash flows after the cutoff date, and
doesn’t give any reference to total profitability of the projects
Liquidity criterion cares more than profitability: the time of reinvorsement more
important than the difference between the initial and final situation.
Example: Discounted payback
*Discount ratio in some way is the cost of the capital
COMPARATIVE ANALYSIS: Discounted payback vs Payback
5. The method of NPV (Dynamic method)
NPV = present (or discounted) value of expected returns
It accepts investments that have NPV>0. The highest NPV is the best option.
Chronological value of money
Financial capital has a dual magnitude: amount (C) and deferral (n). The interest rates are
“rewards” in exchange of renouncing to use money in the present.
Calculating future value: Capitalization
Calculating present values: Actualization
Variants of NPV
When calculating interest rate, remember that r is the same for each tperiod
If cash flows are constant for all years: C1=C2=Ct
If constant cash flows and unlimited time:
NPV is a perpetuity, which means that is equal to the present value of a constant and
perpetual income.
Analysis
Advantages.

NPV takes into account the different maturities of the cash flows
Discounted cash flows are comparable and their sum makes sense
Different projects can also be reliably compared on a NPV basis
NPV solely depends on the forecasted cash flows and the opp. cost of capital (r)
Disadvantages:

Difficulty to establish the opp. cost of capital (r)
Implies an assumption of cash flow reinvestment
How to determine opp. cost of capital (r)?
The interest rate of the financial market is the cost of capital.
The opp. cost of capital is the expected rate of return acquired by not using that money for
other potential investment activities for a given capital. (It is a rate of return that investors
could earn in financial markets)
Each company should establish its own calculative interest rate (opp. cost) based on their
average cost of capital, which is based on its specific financial situation.
The hypothesis of reinvestment of net cash flows
In the NPV it is supposed that the positive cash flows are reinvested immediately at a
calculative interest rate, and that the negative cash flows are financed with resources, which
cost is also the same of the interest rate.
If the reinvestment rate r’=r, it is verified the following:
Example 1:
We will choose project D, because it has the highest NPV
Example 2:
Let’s suppose an investment project with the following cash flows:
Without taking into account the cash flows reinvestment and assuming a cost of capital (r) of
7%, we have:
NPVA= $5,1
Taking into account the interest rate of reinvestment that is 7%, we have:
It is indifferent to collect money at the end of the 3rd year if we can reinvest at 7%:
Taking into account the interest rate of reinvestment (r’) that is 5%, we have:
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