Investment Types and Valuation Methods
Investment Types According to Finality
Maintenance Investments
Designed to maintain the productive capacity of a firm (e.g., renovation of machinery).
Growth Investments
They aim to increase the production capacity of a company. For example, acquiring more modern machinery can increase productivity.
Investment Types According to Relation
Autonomous Investments
These investments are independent of other investments. For example, a company dedicated to the development of “polvorones” decides to invest in Treasuries.
Additional Investments
Two investments are complementary when it is necessary to make both to achieve the objective (e.g., a computer program and training workers to use it).
Alternative Investments
A company has several investment options to achieve its objective.
Investment Types According to Materiality
Physical or Tangible Investments
Those in tangible assets (e.g., merchandise, buildings).
Intangible Investments
Companies make large expenditures to acquire assets that are not tangible (e.g., buying a brand).
Elements Defining Investments in Fixed Assets
- Initial outlay or investment size (A): The amount of money provided to start an investment in fixed assets.
- Investment duration (time horizon).
- Net cash flows (cash flow) (Q): In investments in fixed assets, net cash flow of a period means the difference between the entries of money (collections) and outputs of money (payments) produced during the period.
The Changing Value of Money Over Time: Capitalization and Discounting
The value of money changes over time. One of these reasons is inflation. Other factors also cause the value of money to decrease over time (i.e., if we have 100,000 EUR today and invest in government bonds, in 3 years we will have 112,000 EUR). When we move an amount of money back in time, we are talking about discounting. If we move money forward, it would be capitalization.
Static Investment Valuation Methods
The value of money changes depending on when it is received, but to introduce this concept, it would be necessary to consider capitalizations or discounts so that we always deal with the same moment. Static methods do not take into account the changing value of money, therefore they are less accurate but simpler.
Payback Period
It measures the time it takes to recover the initial disbursement. The payback period does not measure the profitability of the investment but its liquidity. It has two drawbacks:
- It ignores cash flows after the payback period.
- It is indifferent to the distribution of cash flows prior to the payback period.
Dynamic Investment Valuation Methods
These methods are much more suitable than static ones, as they take into account when cash flows occur.
Net Present Value (NPV)
It is the sum of the discounted cash flows at the initial moment minus the initial outlay. According to the NPV criterion, an investment in fixed assets will be achievable if its NPV is positive, and among several investments with positive NPV, the one with the highest NPV will be chosen.
Internal Rate of Return (IRR)
Also called the internal rate of return. The IRR of a project measures its relative profitability, which is the discount rate that makes the net present value calculation of the IRR equal to zero. A project is considered profitable if its IRR is greater than the discount rate. If there are several projects that meet this condition, the one with the highest IRR will be chosen.