Every company needs to anticipate costs and results in order to establish policies based on anticipated data. This planning process by which the company's governing bodies continually design the desirable future and select the ways to make it feasible, works as a global system using the methodology of systems thinking and the joint interaction of all its components.
Financial decisions and planning are critical to the success of any modern organization. Knowing the techniques that are currently used to plan and evaluate financial investment decisions must be part of the vast knowledge that any company manager must master today.
The main objective of a financial administrator is to acquire and use funds with the purpose of raising the capital of the company, for this he must handle concepts that will help him make decisions based on a critical analysis of the concepts and techniques of financial investment of investment projects.
According to Peumans, the investment is any disbursement of financial resources to acquire specific durable goods or production instruments, called capital goods, and that the company will use for several years to fulfill its corporate purpose.
For Tarragó Sabaté the investment consists of the application of financial resources to the creation, renovation, expansion or improvement of the company's operational capacity.
According to the author, an investment is the act where certain assets are acquired in order to obtain future profits. To achieve this purpose the project arises. Gómez defines it as a planning that consists of a set of activities that are interrelated and coordinated; The reason for a project is to achieve specific objectives within the limits imposed by a budget, previously established qualities and a previously defined period of time.
The project is the set of antecedents that allow to measure the economic advantages and disadvantages derived from assigning certain resources of a country for the production of a certain good or service.
According to the author, a project is a proposal to give an idea of what is going to be done and how much an investment will cost, hence, an investment project is a plan where a certain amount of resources will be allocated to produce goods or services for purposes profit.
The evaluation of an investment project is intended to determine the level of economic and financial profitability that is expected from it. This also constitutes a technique that should be taken as a possibility of providing more information to those who must decide, so it will be possible to reject an unprofitable project and accept a profitable one.
In our days an investment requires a well structured and evaluated project in which the steps to follow are established, the correct allocation of resources, being sure that the investment will be really profitable and making a decision of acceptance or rejection.
For investment projects, studies must be prepared, with a greater or lesser degree of depth, that provide information that allows deciding whether or not to undertake the project.
There are two types of investment project:
- Independent: who are those who compete with each other, in such a way that the acceptance of one of them does not eliminate the others from further consideration. If a company has unlimited funds to invest, all independent projects that meet the minimum investment criteria can be implemented. Mutually exclusive: they are those that have the same function. Accepting one among a mutually exclusive project group removes the other projects in the group without any further analysis.
There are various methods or models of investment valuation.
- Net Cash Flow (static Cash-Flow) Pay-Back or Payback Period Accounting rate of return
These methods all suffer from the same flaw: they do not take time into account. That is to say, they do not take into account in the calculations, the moment in which the money exits or enters (and therefore, its different value).
- The dynamic or discounted Pay-Back The Net Present Value (NPV) The Internal Rate of Return (IRR)
These three methods are complementary, since each of them clarifies or contemplates a different aspect of the problem. Used simultaneously, they can give a more complete view.
These parameters are intended to determine a priori whether an investment project is convenient or not from an economic-financial point of view.
In essence, they are based on the comparison of the cash flows that the project has to produce in operations, with the total investment expenses that it requires.
The acceptance or rejection of a project in which a company thinks of investing, depends on the utility that it provides in the future compared to the income and interest rates with which it is evaluated.
Each and every one of these financial mathematical analysis instruments must lead to making identical economic decisions, the only difference that occurs is the methodology by which the final value is reached, therefore it is extremely important to have very clear mathematical bases for its application.
Sometimes using a methodology a decision is made; but if another is used and the decision is contradictory, it is because the indexes have not been used correctly.
Net Cash Flow
Net Cash Flow is understood to be the sum of all receipts less all payments made during the useful life of the investment project. It is considered the simplest method of all, and of little practical use.
There is the variant of Net Cash Flow per committed monetary unit.
Formula:
Net Cash Flow / Initial Investment
Payback Period, Payback Period, or Static Pay-Back
Alarcón Armenteros states that the recovery period is determined by counting the number of years that have to elapse for the accumulation of the expected cash flows to equal the initial investment.
In other words, it is the number of years it takes the company to recover the investment. This method selects those projects whose benefits make it possible to recover the investment faster, that is, the shorter the payback period, the better the project. But this method is not so successful, it does not take into account the value of money over time and also once the investment is recovered, it does not recognize cash flows.
Accounting rate of return
This method is based on the concept of Cash-Flow, instead of collections and payments (economic Cash-Flow).
The main advantage is that it allows calculations to be made more quickly by not having to prepare statements of collections and payments (more cumbersome method) as in the previous cases.
The mathematical definition is as follows:
/ Initial investment of the project
The main drawback, in addition to the defect of the static methods, is that it does not take into account the liquidity of the project, a vital aspect, since it can compromise its viability.
Furthermore, the average rate of return has little real meaning, since the economic performance of an investment does not have to be linear in time.
The dynamic or discounted Pay-Back.
It is the period of time or number of years that an investment needs for the present value of the net cash flows to equal the invested capital.
It implies a certain improvement over the static method, but it is still considered an incomplete method. However, it is undeniable that it provides certain additional or complementary information to assess the risk of investments when it is especially difficult to predict the rate of depreciation of the investment, which is quite common.
The Net Present Value. (GO)
The Net Present Value constitutes one of the most important parameters to analyze when it comes to making an investment, it indicates the level of profit or loss that may or may not imply accepting the investment.
Net Present Value is defined as the difference between the present value of the cash flows that an investment will provide, and the initial outlay necessary to carry it out. It is recommended to make the investment if the NPV is positive.
Is calculated:
Techniques for planning and evaluating financial decisions
Where:
Co = Initial Investment
Cn = Cash flows
r = opportunity cost
t = Time
VAN> 0 the project is accepted.
NPV <0 the project is rejected.
When NPV = 0, this does not mean that the utility of the project is zero. On the contrary, it indicates that it provides the same utility as the best alternative investment. This is because the discount rate (r) used includes the implicit cost of the investment opportunity. Therefore, if a project with NPV = 0 is accepted, all the disbursements plus the profit demanded by the investor are being recovered, which are implicit in the updated discount rate.
Between two mutually exclusive projects, with positive NPV, the one with the higher NPV is accepted.
The NPV amount represents the profit that the project offers to the investor.
Internal Rate of Return (IRR)
The Internal Rate of Return or Profitability (IRR) represents the general profitability of the project and is the discount or discount rate at which the present value of the cash flow of income is equal to the present value of the flow of cash expenses. In other words, it is said that the IRR corresponds to the interest rate that makes the NPV of a project zero, annulling its profitability.
In this way, it is possible to know to what level the discount rate can grow and the project is still financially profitable.
It is an indicator of the profitability of a project, the higher the IRR, the higher the profitability.
The formula to calculate this indicator is as follows:
Techniques for planning and evaluating financial decisions
Yes:
The NPV is positive r1 and r2> r
The NPV is negative r1 and r2 <r
The project will be accepted if the IRR is greater than or equal to the opportunity cost (r).
The updated Cash-Flow (or discounted)
We can consider this method as a variant of the accounting Rate of Return. It takes the gross profit before amortization for each of the years of the project's useful life, and updates or discounts them according to an interest rate. It allows simpler calculations than the methods that work with forecasts of collections and payments.
However, unlike the accounting rate, this method does take into account the liquidity of the project at the level of the cash flow generated in each of the years of the investment time horizon.
The cash flow of the project
Given that the investment process is expressed as a stream of collections and payments that occur over time, the evaluation of an investment is carried out taking into account -precisely- this stream. However, as this is an estimated stream of collections and payments, it is essential to know how to make the cash flow projection and what are the elements involved.
We will therefore examine the characteristics of the calculation (forecast) of Income, Investment Cost and Total Production and Service Costs, that is, the fundamental elements that serve as the basis for calculating cash flows. and in general to conform to the various investment evaluation criteria.
Income.- These depend on two variables: sales volumes and prices. The calculation of sales volumes implies previously determining the production program, which in turn depends, among other factors, on the analysis and projection of demand, the demand-capacity balance for the different projected years, the market share, the useful life of the project, the capacities to be installed and their level of use, and so on.
Regarding prices, despite the associated doubts and uncertainties, a study is required where the prices of inputs and products are forecast with some rigor. It is also necessary to distinguish between internal prices and external prices, and the conversion of external to internal prices by using the corresponding exchange rate.
Investment cost: the total value of a new investment project is generally structured in: fixed assets or capital, working or operating capital and contingencies, as regards capital or fixed assets, it is made up of fixed investments and the cost of capital prior to production.
The operating capital or working capital is the permanent capital necessary to finance that part of current assets that are not covered by current liabilities. Therefore, it is generally defined as the difference between current assets and current liabilities. Due to its nature, this is a current asset, but due to its economic function it is a fixed asset and, therefore, it is part of the investment cost.
In a general sense, we can say that there are various techniques to evaluate an investment project, such as: The Present Value, the Net Present Value, the Internal Rate of Return, the Payback Period, among others, which are neither given nor the use or the importance they require to be able to define if it is really profitable or not to execute a project and that it is able to recover with its own results.
