The general objective of this report is to “Analyze the financial elements to consider when evaluating an investment decision”. Corporate finance is a fascinating field, considering it as one of the areas where the impact of decisions made by managers in companies is reflected.
The decision to invest is one of the most complex that companies have to make, it involves an evaluation of the businesses available as well as their profit potential given a level of risk, that is, the possibility that losses may be incurred and not be able to recover the capital invested. In this report we will approach the evaluation of investments using sophisticated methods that take the value of money over time such as the NPV and the IRR.
Then the asset valuation model that considers the required profitability of an investment portfolio considering the level of risk. The expected return is estimated from the risk-free rate and the Beta coefficient that measures the level of risk of an investment. The efficient investment portfolio is based on a set of investments with diversified risk that exceed the expected profitability for determining the efficient investment frontier. The report is based on various bibliographic sources and on the experience of the student in the area of project evaluation. Key words: profitability, investment, risk, assets, portfolio.
INTRODUCTION
The fascinating field of investment appraisal is considered one of the areas where the impact of decisions made by managers in companies is most intensely reflected. The decision to invest is one of the most complex that companies have to make, it involves an evaluation of the businesses available as well as their profit potential given a level of risk, that is, the possibility that losses may be incurred and not to recover the invested capital.
In this report we are going to approach the evaluation of investments using sophisticated methods that take the value of money over time and then the asset valuation model that considers the required profitability of an investment portfolio considering the level of risk.
The report is based on various bibliographic sources and on the experience of the student in the area of project evaluation.
The defined general objective was to “Analyze the financial elements to consider when evaluating an investment decision.
The two specific objectives to be achieved are: 1) Describe the usefulness of the NPV and the IRR to evaluate investments ”2) Show the benefits of the asset pricing model” in determining the efficient investment frontier.
CHAPTER 1. INVESTMENT EVALUATION
Business management, when seeking to maximize profits, turns to investments to create value for shareholders. Shareholders benefit from value creation that takes the highest form of return, consisting of dividend income collected and capital gains from increased share prices. So the first big question in corporate finance explores the conditions under which new investment projects, such as building a new factory or modernizing an existing one, add value to the company. Analyzing the usefulness of the NPV and IRR for the evaluation of investments, the first specific objective of the report will be met.
To create shareholder value, managers apply a method of evaluating investment projects to determine their feasibility. Project evaluation involves estimating in advance the costs associated with the project, comparing it with the expected revenue stream. To do this, discounted cash flow is used, a method that takes into account both the value of money over time and the risk of the investment.
Net present value and discounted cash flow
The basic principle of the value of money over time is that a dollar today is worth more than a dollar tomorrow. Because one dollar today, you can place it in the bank earning interest and have more than one dollar tomorrow. The basic principle of risk is that a dollar on hand has more value for an investor than a dollar in the future. In the context of evaluating investments, costs can be assumed to be true, but income can only be forecast. For many reasons, actual cash flow may not meet projections. Business management should consider not only profitability but risk when considering the decision to invest in a project. The most used tool to evaluate investments is the Net Present Value (NPV),that allows converting a cash flow stream generated over time into a single figure expressed in monetary units (Bs, $,) today.
It is observed that the value of the project for a company in monetary units today is equal to the initial costs of the project (negative figure) plus the net income stream discounted at the discount rate given an accepted and a required profitability. The rule for making decisions that if the calculated NPV is positive, the investment adds value to the company so it must be accepted. If the NPV is negative, the investment does not add value to the company and therefore must be rejected.
The discount rate is a critical factor used to adjust cash flows to time and risk. The discount rate is made up of two components: the "risk-free" rate, which is the return that the company could obtain by placing its resources in a completely secure bank account or by buying treasury bonds. To this risk-free rate, a “risk premium” must be added, which is the additional amount that the company must pay investors for the risk associated with the business. One rule is that the higher the risk, the higher the required return. Another is that the higher the discount rate, the lower the calculated NPV will be and the less attractive the project will be. Figure 1.1 shows cases of leading companies with the decisions they made to generate added value in their businesses.
| BUSINESS | BUSINESS |
| Packaging design | Absolut vodka has become a collector's item for the design of its bottles not only for drink lovers but also for art lovers. |
| Introduce a new product | Apple's products stand out for presenting constant modifications, for being perfectible and for seeking to satisfy more and more the needs of its consumers. It is no wonder that Steve Jobs has patented over 300 inventions. |
| Introduce variations of existing products | Ford introduces the Sierra |
| Lean on marketing to create product differentiation | Coca cola uses the slogan "The taste of life" |
| Exploit new technology | Yahoo uses banner on the web. |
| Quality of service and attention | McDonald's main commandment for its employees is to attend with a smile, while at Starbucks they ask for your name. |
Fig. 1.1 Companies that create a positive NPV. Own elaboration
The value of money in the time. Case of a single period.
Here Juan Brown, landowner, is supposed to be trying to sell a lakefront lot in Aruba for what they are offering him $ 10,000. When he was about to close the deal, another buyer called him and offered him $ 11,424, on the condition that he be paid within a year. Payment is guaranteed and there is no risk of default. Juan calls his financial analyst, who informs him that if he accepts the first of the proposals, he can invest that amount in a 12% bank, so at the end of the year Juan would have $ 11,200. Since that amount is less than the $ 11,424 offered by the second buyer. The analyst encourages Juan to accept the second offer.
The financial analyst's reasoning is based on a critical concept of corporate finance, he has used the concept of future value that is value of a sum after investing it for one or more periods. In the example, the future value of $ 10,000 at compound interest is $ 11,200.
Now the analysis is turned around and we will look at it from the perspective of the so-called "present value" of a future sum. This value can be determined by answering the following question: How much money should Juan put in the bank today to have $ 11,424 next year considering an interest of 12%?
VA * 1.12 = $ 11,424 or what is the same VA = ----– = $ 10,200
Generalizing we have
?
?? =
(1 +?)
Where C1 is the cash received at the end of the single period and r is the appropriate interest rate or discount rate to apply. The analysis says in the example that the future payment of $ 11,414 made by the second buyer next year has a present value of $ 10,200 this year. As this figure is greater than the first buyer's $ 10,000 offer, the analysis informs Juan that it is in his best interest to accept the second offer at least if the discount rate is 12%.
Net present value without risk
Bob Zubillaga of the real estate company "Real estate dc" has a business of land that is worth $ 85,000 that would be the initial investment. Bob hopes to resell it for $ 91,000 next year which would be the future payment. The operation has a safe profit of $ 6,000 for what appears to be a good investment. But is it really? If the risk-free discount rate is 10%, which is the interest rate offered by the bank. Using the equation the present value of the land with a future value of $ 91,000 would be:
$ 91,000
??????????? = = $ 87,727
1.10
With this information we apply the VAN formula
$ 91,000
- $ 2,273 = - $ 85,000 +
1.10
Since the NPV is negative, Bob Zubillaga will recommend not buying the land. In this example, the VAN equation can be written like this: VAN = -Inversion + VA
Present value in projects with multiple periods with risk
TECINTER is considering the construction of a new manufacturing plant with an initial cost of $ 100 million. Market projections indicate that the plant will generate a cash flow of $ 10 million in the first year, 20 million for the second year, 30 million for the third year, 40 million for the fourth and 50 million for the fifth year. The company invests 100 million and receives 150 million in 5 years. Will it be a good business?
Looking further, the prospects are less optimistic. For starters TECINTER faces a money value problem over time because a good part of the expected cash flows arrive in the last 3 years of the project. Which is little compared to the risk of building a new plant. We know that the semiconductor sector is highly cyclical, so that in bad times the cash flow could be substantially less. In addition, in the sector there is usually excess manufacturing capacity, and depressed prices due to excess supply, so that even in good times the company may not achieve the expected cash flows.
To calculate the NPV of the project using the equation, with the assumption of a risk-free rate of 10% we would have using the financial function of EXCEL the result would be:
| YEAR | FNC |
| 0 | -100 |
| one | 10 |
| two | twenty |
| 3 | 30 |
| 4 | 40 |
| 5 | fifty |
| GO | $ 5.93 |
Since this VAN is positive TECINTER, you must build a new plant and in the process would add more than $ 5.93 million of value to the company.
But if you add the risk you will see how the calculation can vary. As a first step to justify the risk we can assume a higher discount rate, say 15%. An investor in a risky project is supposed to ask for a higher "risk premium" that is above the all-risk-free rate he could earn by placing his money in a bank or short-term treasury bonds. In this case the risk-free rate is 10%, the risk premium is 5%, the assumed discount rate is 15%. The NPV calculation is as follows using the Excel financial function. The result gives a negative NPV of $ 7.59 million.
YEAR FNC
- -1001020304050
VAN $ -7.59
Immediately it is seen that this investment would not be profitable for the company since it would lose $ 7.59 million in value given the calculated negative NPV. This calculation highlights the importance of choosing the appropriate discount rate to assess a project.
The internal rate of return
The net present value measures the value added of an investment to the company. The IRR, for its part, measures the profitability of an investment in percentage terms. If the rate of return is above the minimum required, the investment is accepted. If the projects are exclusive, the one with the highest profitability is accepted.
In mathematical terms, the IRR is represented with this model, it would be the value r that makes zero the current value of an investment.
?
0 =
(1 +?)
In the TECINTER example with the initial investment and the cash flow generated by the project, the calculation could be made using Excel's financial formulas. The results indicate that the calculated IRR is 12% above the 10% discount rate, which makes the investment feasible.
YEAR FNC
- -1001020304050
IRR 12%
VAN Bs. 5.93
The choice of the discount rate.
Choosing a discount rate is one of the most difficult tasks for financial executives, in the previous example you have guessed what it could be, but instead of 15% it could be 20, 25 and even 30%. So how is the true discount rate calculated? The most common way is to use one of the most important and powerful financial tools, called CAPM "capital asset pricing model" in Spanish translated as "capital asset valuation method" that will be discussed in the next chapter..
CHAPTER II. THE CAPM. THE INVESTOR'S PERSPECTIVE
When the investment problem is viewed from the investor's perspective, corporate finance becomes considerably more interesting, because it is not just about managers trying to create a profitable company, but rather investment banks, portfolio managers and financial planners with the intention of making money in the stock and bond markets. This chapter will fulfill the second specific objective of the report.
The question that is asked is whether the investment proposed by the company will increase or decrease the price of its shares. In other words, if investors believe that the project will add value to the company by generating a positive NPV, their shares should go up in price. But if investors believe that the project will detract from the company's value, its share price should drop.
One of the most important principles of corporate finance is that at any time the price of the company's shares reflects an expectation of future earnings. So if the market has news of an investment project that changes expectations, the share price should change.
The CAPM equation
The model equation is described below. On the left side there is the expected return of a security, which is the discount rate of own capital that we are trying to estimate. The model says that this expected return (Re) can be calculated by adding the risk-free rate (Rf) to the difference between the expected market return (Rm) and the risk-free rate (Rf) multiplied by the beta value (?) of the title.
?? = ?? +? ↔ (?? - ??) Performance performed.
The risk-free rate is what you can certainly earn with a short-term treasury bond. What needs to be defined is how the risk is defined between the expected return of a security and its realized return. For shareholders, the return made in a year is made up of two components: 1) the dividends generated by the shares 2) the capital gain or loss, that is, the gains from changes in the share prices.
If 100 shares of pharmaceutical company BISAX Inc. were purchased at the beginning of the year, for $ 37 a share. Throughout the year, he paid a dividend of $ 1.85 per share, or $ 185 for his 100 shares. In addition, at the end of the year the securities were worth $ 40.33 per share. This represents a net gain of $ 333.
The realized return on investment is calculated first with the dividend yield the dividend received between the purchase price: 5%. Then the percentage of capital gain, which is 9%. This means that the total realized return is 14%.
The expected return and the risk-free rate
The expected return on a security is what investors believe will be the rate of return at the end of the period, usually one year. The expected return on a security can vary significantly from the realized value, which is the very essence of the concept of risk.
Systematic risk and diversifiable non-systematic risk
The unforeseen part of the risk that results from surprises is the true risk of any investment. If what is expected is received there would be no risk or uncertainty. In any case, there are important differences between the different risk classes, so it is useful to divide it into two components: "systematic risk" and the rest called "unsystematic" or "diversifiable"
The “systematic risk” affects many elements of the asset to a greater or lesser degree, for example uncertainty about the country's economic conditions, GDP, inflation, interest rate, currency devaluation are an example of this type of risk. An increase in the general level of prices affects the wages and costs of companies' supplies. The nature of this risk is mainly cyclical, when there is economic expansion, market returns are considerably higher than those obtained during recession periods.
Unsystematic risk represents the unanticipated part of a company's performance as a result of events unrelated to overall market performance. It is a risk that affects a single element of the asset or a small group of those elements. A strike at a PDVSA may affect only this or a few others, but it is unlikely to affect world oil markets. In the same way, a biotechnology company may face the risk of failed trials of a new medicine, a technology company with lawsuits in courts for the use of patents, and thus risk losing market shares and profits with the competition. from other companies in the sector.
The distinction between systematic and unsystematic risk is not accurate as presented, because even the smallest information about a company can affect the economy. By dividing the risk into its two parts, two important points are reached: 1) the unsystematic risk can be diversified by dividing it within a portfolio and 2) the systematic risk can be measured with the “beta value” using the CAPM or valuation method of the cost of own resources.
Beta value
If a company's stock price rises faster than the active market at good times and falls faster than the market at bad times, that company is said to be more risky than an investment in the active market. These companies have a Beta greater than one. Betas above one represent high systematic risk and reflect higher volatility than the market. This description fits companies belonging to highly cyclical sectors such as technology.
If the stock price rises more slowly than the market in good times and falls slower in bad times, the company is less risky than an investment in the active market, and will have a Beta value less than 1, which represents low systematic risk. This description is valid for mass consumption sectors such as food, medicine and beverages.
Suppose financial analysts consider four possible states of the economy: depression, recession, expansion, and boom. In we consider buying shares of two different companies TECINTER AND BISAX. Given that the former operates in the highly cyclical semiconductor sector, its returns are expected to follow the economy very closely. Second, because it offers products that consumers need in both good and bad times, its returns are expected to be less cyclical.
In the four scenarios simulated by analysts, the simulated returns are as follows:
| Tecinter expected returns% | Expected returns Brisax% | |
| Depression | -twenty | 6 |
| Recession | 12 | 25 |
| Expansion | 38 | -12 |
| Boom | 55 | 10 |
Table 2.4 Expected returns Source: own elaboration
It is observed that the yields made by TECINTER tend to be higher in good times and lower in bad times. Secondly, the returns made by the two companies sometimes move in different directions. These two effects volatility and joint movements are called variance and covariance in statistical language.
A positive relationship or covariance between the two values increases the variance of the entire portfolio, which is not recommended if the aim is to diversify the risk. Conversely, a negative relationship or covariance between the two values decreases the variance and the risk of the entire portfolio.
If one of the values tends to rise when the other falls or vice versa, both values compensate each other. This effect in finance is called “hedging” and the risk of the entire portfolio will be less. But if the two stocks rise and fall together there is no hedging and the risk of the entire portfolio will be higher.
The concept of "hedging" is important because it is a way to diversify the unsystematic risk in the stock market, it will be investing in securities of companies belonging to different sectors, if an investor has shares in Intec and in another company in the same semiconductor sector., it will normally be less diversified than another investor that has shares in addition to semiconductors in another sector such as the pharmaceutical.
What is wanted to emphasize is that the variance of a portfolio depends as much on the variance of the individual values as on the covariance between both values. So to search for a diversified portfolio, the investor is interested in the contribution of each security to the expected return and risk of the portfolio, that is, the systematic risk.
THE OPTIMAL PORTFOLIO OF THE INDIVIDUAL INVESTOR.
In any investment there is a trade-off between the expected return and the possible risk of not getting that return. Investors will choose some combination of assets that maximizes the expected returns with a given level of risk.
The set of opportunities
The first step in building an optimal portfolio is to define the set of opportunities or viable set of investments that can be chosen. Figure 9.6 illustrates the different combinations of securities that investors can make within a set of opportunities that only two companies have. The vertical axis represents the expected returns, the horizontal axis shows the standard deviation of the portfolio's return, which is the risk indicator, represented by the square root of the portfolio's variance, which is relatively less risky. It has an expected return of 5.5% and a collateral indicator of risk of 11.5%. Point B instead shows a portfolio of the riskiest company, represented by a much higher standard deviation of 26% and an expected return of more than three times that of the other company.
The straight line between point A and B assumes that the correlation between both companies is exactly equal to 1, which says that the returns of both companies move together. The curve above the straight line reflects the assumption of a negative correlation between the returns of both companies.
This negative value means that the returns between these two companies tend to move in opposite directions, so there will be a diversification effect and a coverage opportunity. The points of the curve offer the best combinations of expected return in exchange for an expected risk, it is the so-called efficient frontier of this portfolio.
The diversification effect and the efficient frontier
The diversification effect can be seen by comparing points 1 and 4 of the figure. In both cases they represent a portfolio made up of 90% and 10% of each company, however point 1 supposes a diversification effect and point 4 does not.
There is a point marked VM on the curve to indicate minimum variance. This represents the combination of two values with the lowest possible risk. Curiously, point VM is to the left of point A and between these two points the line curves backwards, which means that DSta is a very low risk value and an investor can even reduce it further by selling part of it and replacing it with Sutech's increased risk. Here the diversification effect is shown in all its splendor and is one of the most important conclusions in corporate finance.
Finally, it is expected that no investor would want to have a portfolio with an expected risk less than the minimum variance. No investor would choose to have portfolio 1 even though it is viable and on the efficient frontier. Such portfolios are said to be dominated by the minimum variance portfolio, that is, although the entire curve from DSta to Sutech is called a “viable set”, only the part of the curve from VM to STech constitutes the true efficient frontier..
In addition to the concept of building the optimal portfolio, one must understand the concept called the “separation principle,” which says that the decision to invest is actually a two-step process in which the investor first calculates the efficient set of assets. risky and then combines a special portfolio of those assets with risk-free ones (treasury bonds) based on their level of risk aversion.
CONCLUSIONS
In an environment of limited resources, companies must apply criteria that allow adding value to their businesses, so they must apply sophisticated instruments to evaluate their investments. The NPV allows decisions to be made to measure the benefits of a project with the ability to add value the company, only those investments that have a positive NPV will be accepted, considering a risk level, expressed in the accepted discount rate. The IRR measures the expected return on an investment measured in percentage terms, only projects that exceed the minimum required return will be accepted. In this way, the first objective of the report "Describing the usefulness of the NPV and the IRR to evaluate investments" is fulfilled in Chapter 1
The "asset pricing model" uses the beta coefficient to link an asset's market risk to its required return. Beta measures unsystematic or diversifiable risk by expressing the degree of risk response of an asset to any change in market returns. The risk-free rate measures the safe expected return on an investment. The yield on the treasury bonds is used as a reference for its calculation. Companies with Beta greater than 1 are considered very risky, companies with Beta less than 1 are considered very risky. Investment diversification involves the creation of a portfolio with differentiated risks and profitability, this is known as “hedging”. The higher the risk, the higher the required return, the lower the risk, the lower the required return.Building an optimal investment portfolio requires understanding the diversification effect between high risk assets and low risk assets. No investor would like to have a portfolio with an expected return of less than the minimum variance. In this way, the second specific objective “To show the benefits of the“ asset pricing model ”in determining the efficient investment frontier” is fulfilled.In this way, the second specific objective “To show the benefits of the“ asset pricing model ”in determining the efficient investment frontier” is fulfilled.In this way, the second specific objective “To show the benefits of the“ asset pricing model ”in determining the efficient investment frontier” is fulfilled.
With the fulfillment of the two specific objectives, the general objective of "Analyze the financial elements to be considered when evaluating an investment decision" is fulfilled.
REFERENCED BIBLIOGRAPHY
GITMAN Lawrence. Basic Financial Administration. Harla 4 2010 edition.
NASSIR Sapag Chain. Investment projects. Formulation and Evaluation. Person from Mexico 2010
NAVARRO Peter. What the best MBAs know. Editorial Profit 2009
VAN HORNE James. Fundamentals of Financial Administration. Prentice Hall 2010
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