Chapter 4. Investment analysis methods Summar (2016)Resumen Inglés
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TOPIC 4: INVESTMENT IN A COMPANY,
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 (long-term, 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/non-planned 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 cut-off 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 cut-off 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 cut-off 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 t-period 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.
- 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: ...