Investment Concepts, Cash Flows, and Project Evaluation

Posted on Dec 2, 2024 in Economy

1. Concept of Investment

Definition of Investment

Investment is the disbursement made to earn income exceeding the initial payment.

Definition of Investor

An investor is a person or company that provides the expenditure required for investment. Investments can be classified based on the investor’s role:

  • Economic Investment: The investor manages the project and directly produces goods or services.
  • Financial Investment: The investor only provides capital.
  • Social Investment: Aims for societal improvement rather than direct economic benefit (e.g., state health investments).

Investments can also be classified by their source:

  • Renewal Investments: Replace and modernize company capital (machinery, vehicles, etc.).
  • Expansion Investments: Acquire new premises, equipment, etc.
  • Innovation Investment: Expenditure on Research, Development, and Innovation (R&D+I).

Classification by materiality:

  • Real Investments: Purchase of raw materials, machinery, etc.
  • Service Investments: Hiring professionals for company benefit.

Classification by type of capital invested:

  • Human Capital Investment: Resources to enhance worker skills (e.g., English courses).
  • Technological Capital Investment: Improvements in systems and production processes.
  • Physical Capital Investment: Purchase of ships, machinery, etc.

In relation to other investments:

  • Autonomous Investment: Earns income independently of other company activities.
  • Additional Investment: Returns result from the interaction of new capital.
  • Alternative Investments: Capital replaces a damaged one.

2. Cash Flows

Cash flows are the inflows and outflows of money in a company:

  • Inflows: Sales revenue, returns on financial investments, loans, etc.
  • Outflows: Expenses for product sales, money spent, etc.

Treasury Management: Ensures sufficient funds to cover payments if inflows are lower than outflows. If there’s a surplus, it needs management. Companies should have enough money to meet expenditures but avoid excessive funds, as it’s preferable to invest for profitability.

3. Time and Money

Financial Equivalence Equation

A formula that equates capital at a specific time (C0) with its equivalent at a later time (C):

C = C0 * (1 + i)t

  • Interest: Gain or compensation for lending money.
  • Interest Rate (i): Cost of having a unit of money for a period of time. i = I / C0
  • Compound Capital Law: If the period exceeds one year: C = C0 * (1 + i)T

Concepts

  • Final Value (FV): Future amount of capital. FV = C * (1 + i)T
  • Present Value (PV): Amount equivalent to today. PV = C / (1 + i)T

Final value and present value are equivalent when the interest rate is consistent.

4. Assessment and Selection of Investment Projects

Various criteria determine investment profitability and help choose the best alternatives:

Static Criteria

Do not consider the timing of cash flows, but focus on:

  • Payback Period (PAYBACK)
  • Total Net Criteria

Dynamic Criteria

Analyze present value and Internal Rate of Return (IRR).

4.1 Payback Period

Number of years to recover the initial cash outlay from investment cash flows. Projects that do not recover the initial investment are discarded, and those with shorter payback periods are preferred.

Discounted Payback Period: Uses the present value of cash flows to determine the recovery period.

Advantages:

  1. Simple to estimate.
  2. Considers the recovery time of the initial investment.

Disadvantages:

  1. Does not account for income earned after the payback period, potentially favoring projects with long-term benefits only.