Investment Characteristics and Selection Methods

Posted on Feb 9, 2025 in Business Administration and Management (BAM)

Characteristics of an Investment

The financial characteristics of an investment are:

  1. Down Payment (D0): The amount the company pays at the time of purchasing the assets.
  2. Duration of the Investment (n): The number of years during which the investment will produce inflows and outflows of money.
  3. Net Cash Flows or Quasi-rents (Fi): The difference between receipts and payments that the company supports over each of the n periods of the investment. Net cash flows are the difference between charges (which is the realization of income) and payments (which are the actual departure of money for compliance spending) and not between income (which are the rights that companies have to be paid their money) and expenditures (which are obligations that companies have following the implementation of a project).
  4. Residual Value (R): The value of the property at the end of the life of the investment.

Methods of Selection and Valuation of Investments

Financial management is responsible for assessing and selecting the most suitable investment. The resources available to the company are limited, so it cannot make all the investments that are proposed and should establish strict criteria to select among different investment alternatives. Virtually, the evaluation criteria and selection of investments are based on achieving the best value for money.

We differentiate the methods for selecting investments into:

  • Static Methods: Based on the assumption that the value of money is constant over time.
  • Dynamic Methods: Take into account the different value of money according to the time when cash flow occurs.

A. Static Selection Methods

Criterion-Term Recovery or Pay-back: Its objective is to determine the number of years it takes to recover the initial outlay.

B. Dynamic Selection Methods

  • Criterion-Net Present Value (NPV): This method updates all the net cash flows to the present and obtains the capital value at this time. The amounts must be added or subtracted according to whether they represent cash inflows or outflows caused by the investment. If the NPV is negative, it means that the total sum of the outputs is greater than the sum of entries. If the NPV is positive, it means that the sum of all entries is greater than the sum of the outputs.
  • Criterion of the IRR or Internal Rate of Return (IRR): The IRR is the discount rate or discount, represented by r, that makes the NPV value equal to 0.
  • If r > i, the investment should be made because a higher return than the market is obtained.
  • If r = i, the investment firm is indifferent and will not win or lose.
  • And if r < i, the investment does not matter, since the profitability that could be obtained is less than the market.

C. Average Period of Maturation of a Commercial Enterprise

Companies engaged in sales have three sub-periods:

  • Sub-period of Supply and Storage: This is the time that the goods are in the company’s warehouse until they are sold.
  • Sub-period of Recovery: This is the time it takes the company to collect sales and customer payments.
  • Sub-period of Payment: This is the time that the company takes to pay suppliers.