Investment Decisions: Concepts, Types, and Selection Methods

Posted on Feb 20, 2025 in Economy

Investment Decisions

1. Concepts and Types of Investments

Investments are classified as:

  1. Fixed Assets and Current Assets
  2. Financial Investments and Productive Investments

Productive investments are further classified as:

  • Replacement investment to maintain the company (to replace worn equipment)
  • Replacement investment to reduce costs or for technological improvements (replacing equipment)
  • Investment for expansion of existing products or markets (to increase the production of existing products)
  • Expansion investment in new products (to develop new products)
  • Imposed investment (not made for financial reasons but to enforce laws, union agreements, etc.)

2. Company Activity Cycles and Average Maturation Period

Short Cycle: This cycle involves acquiring raw materials, storing them until they are used in the transformation process, manufacturing the products, storing the finished products, selling them, and collecting payments from customers to recover funds.

Long Cycle: Fixed assets are consumed or used over time through depreciation processes.

Phases of the Short Cycle:

  1. Storage of Raw Materials: Raw materials are purchased and enter the store at cost price.
  2. Manufacturing Value: Raw materials are consumed, and their cost determines the cost of semi-finished products as factors are incorporated.
  3. Storage of Finished Goods: The finished product is placed in the warehouse until it is sold. Its value is determined by adding costs to factors.
  4. Collection: The sale of production reduces the value of the warehouse of finished products, but the value of credit on customers increases.

3. Fundamental Variables Defining an Investment Plan

A) Relevant Variables of Investment:
The required profitability of an investment must be greater the larger the risk.
B) Cash Flow:
The difference between the charges generated by the investment and the payments required at that moment in time.
C) Effect of Inflation and Risk on the Value of Money:
Profitability: Expected return (the return expected from the investment) – Required return (the return demanded for the investment). Investments are made if the expected return is greater than the required return.

Formula:

K = i + g + ig

Where:

  • K = Profitability when investment returns
  • i = No inversion rate
  • g = Rate of inflation

4. Static Methods for Investor Selection

These methods do not take into account the fact that capital has different values over time.

Recovery Period (Payback Period):

The period of time it takes to recover the initial outlay of cash flows.

Formula:

P = A / Q

Where:

  • P = Payback period
  • A = Down Payment
  • Q = Cash flows are equal and constant

Disadvantages:

  1. Does not take into account the times when cash flows are generated.
  2. Does not take into account additional cash flows.
  3. Treats euros in different years as if they were homogeneous.

5. Dynamic Selection Methods

  1. Net Present Value (NPV):

Formula:

NPV = PV - A

Where:

  • PV = Present Value
  • A = Payment

Investment is made if NPV > 0

Investment is disregarded if NPV = 0

Investment is not incurred if NPV < 0

  1. NPV as a function of the type of update or discount: Simple investment (consisting of an initial outlay and a subsequent set of cash flows (nonnegative))
  2. Type of return or internal rate of return (IRR): The discount rate “r” that makes NPV = 0.

Investment is made if R > K

Investment is disregarded if R = K

Investment is not incurred if R < K

Formula:

rR = (ra - g) / (1 + g)

Where:

  • ra = Apparent profitability

Formula:

i = (k - g) / (1 + g)