Investment Selection Methods and Business Growth
Reasons for Investment Decisions
Investment decisions are typically driven by several factors:
- Modernization or replacement of equipment
- Capacity expansion
- Creation of new products or markets
The goal is to generate cash flows, which can be as simple as a single payment and collection, or a series of monthly payments and collections.
Investment Selection Methods
Static Methods:
These methods do not take into account the time value of money or inflation, making them less accurate and realistic. They are primarily based on liquidity.
Equivalence of Capital: Money’s value changes over time (e.g., €1 today is worth more than €1 in the future). This concept acknowledges that money loses value in the long term; the same monetary amount will buy less in the future.
Inflation: A general increase in prices, particularly in developing economies.
1. Payback or Recovery Period: This determines the time it takes to recover the initial investment using the cash flows generated by the investment.
Cash Flows (F): Payments generated by the investment each year.
Dynamic Methods:
These methods incorporate the time value of money and consider the equivalence of capital and inflation, providing a more realistic assessment.
1. Net Present Value (NPV): The difference between the total present value of cash inflows and outflows, discounted at a rate representing the cost of capital. It indicates whether the investment will generate profit or loss.
- If positive, the project should be undertaken as it will increase the company’s wealth.
- If negative, the project should be rejected.
- If zero, the project is indifferent as it will generate neither profit nor loss.
2. Internal Rate of Return (IRR): The discount rate at which the present value of cash inflows equals the present value of cash outflows, making the NPV zero. Manual calculation is complex and involves trial and error.
Procedure:
- Choose an interest rate representing the cost of capital (e.g., a risk-free investment).
- If NPV is negative, test with a lower rate; if positive, test with a higher rate. Continue adjusting until the IRR is approximated.
(For a project to be viable, its return must be higher than a risk-free investment or the cost of capital. If a project’s IRR is greater than the cost of capital, the investment is advisable. If it’s lower, the project should be rejected. If it’s equal, the decision is indifferent.)
Example: Wood Sector Company Investment
A company in the wood sector has an investment opportunity with the following characteristics:
- Project duration: 2 years
- Initial investment: €1,100,000
- Annual cost of capital: 4%
- Expected cash flows: €450,000 in the first year and €800,000 in the second year
Calculate and interpret the payback period and NPV.
Payback Period Calculation:
After the first year, €650,000 remains to be recovered.
Using a proportion:
12 months / €800,000 = X months / €650,000
X = (12 * 650) / 800 = 9.75 months
0. 75 months * 30 days/month = 22 days
Payback Period: 1 year, 9 months, and 22 days
NPV Calculation:
NPV = -Initial Investment + Σ [Cash Flow / (1 + i)^n]
NPV = -1100 + 450 / 1.04 + 800 / (1.04)^2 = €72,330
The company would benefit by €72,330 if it undertook the investment project. Therefore, it is advisable to proceed.
The project’s IRR exceeds 4% (the cost of capital), indicating that the project’s profitability is higher than 4%.
Business Management and Growth
This involves procedures, tools, and models that explain the decision-making process of senior management for long-term planning.
The Process of Design and Decision-Making
The process begins by defining the company’s long-term goals. These must be realistic and achievable. Then, the company considers the necessary resources and different strategies to achieve these goals. Each strategy has associated risks, costs, and consequences. The company aims to choose the strategy that most efficiently achieves its goals.