Strategic Business Investments: Types, Risks, and Selection Methods
Types of Investment
Increased market share for products the company produces and sells:
- Extension of the distribution network
- Improvement of product quality
- Implementation of marketing strategies
The development of new products is essential for the company, allowing access to broader market segments. Do not forget that in a market characterized by monopolistic competition, launching new products or strategies of differentiation are essential factors of competitiveness. Companies must spend a significant portion of their budget on research and development tasks.
The reduction of costs associated with production and marketing in order to have a wider profit margin:
In competitive markets, where the company has little ability to fix prices, cost savings are a crucial factor in generating or increasing the number of benefits.
The maintenance or expansion of the productive capacity of the company:
- The replacement of outdated or depreciated equipment to maintain the ability of the company
- The purchase of new equipment to increase the productive capacity of the company
Investment Types Based on Assets
Investment in real assets: Investment in real assets is active in participating in the production process, such as machinery or transport elements.
Investment in financial assets: Financial assets or values correspond to the titles, such as shares or bonds of another company or public debt, the company acquires.
Investments According to Term
Investment structure: Corresponding to those incorporated in the fixed assets of the company.
Investment in capital: These are part of the working capital of the company, such as increased investment in stocks of raw materials or finished products.
Investments Based on Payment Structure
Investment with various payment and billing: If a company buys a machine paying cash, a payment is recorded, and a flow of future payments arises. The incorporation of the machine into the production process and the consequent increase in production or marketing of the product is subject to the activity of the company.
Investment with a single payment and collection: Sometimes, there may be a single future payment. This might be the case of a company that acquires land with the intention to resell later for a higher price.
Investment with several payments and a single payment: This situation can occur if the amount of the asset is paid in multiple payments, while the sale is made in cash.
Investment with multiple payments and multiple payments: As you can imagine, the combination of modalities shown in previous sections can be given.
The Risk Associated with Investment
There are several decision criteria under risk that we developed in the first units. If you know the probabilities associated with each of the possible results of an investment, you can use the criterion of expected value. The existence of a certain degree of risk will result in the existence of a risk premium, which reflects an additional cost of financing the investment.
Comparison of Capital
Payments and collections associated with an investment occur over time. This fact complicates the comparison between the capital, the opportunity cost, and inflation.
Inflation
It’s the loss of purchasing power experienced by a currency over time. We define inflation as the generalized and continuous growth of prices of goods and services in an economy. The effects of inflation on the economy are diverse. From the standpoint of the comparison of capital, it is necessary to take into account changes in the purchasing power of currency when comparing income streams and expenses. If this has not changed, the purchasing power of money is at risk of erroneous decisions.
Capitalization
Capitalization consists of calculating the value of a certain future capital from the knowledge of interest rates.
Updating
We understand the calculation of capital to upgrade the current value of specific capital that is perceived in the future.
Methods for Selecting Investments
As we have seen above, risk is an essential component in any investment. There are many ways to confront this fact. From this point of view, the selection of investments can distinguish between static and dynamic methods.
Static Methods
Static methods do not consider the problems arising from the equivalence of capital. For this reason, they are approximate methods, of which the most important is the recovery period or payback.
Dynamic Methods
Dynamic methods incorporate the time factor and consider that the funds have different values depending on the moment in time. The main dynamic methods are Net Present Value (NPV) and Internal Rate of Return (IRR).
The Payback Period Method
It is the time period in which charges that occur as a result of the investment equal the expenditure incurred.
Drawbacks: It only considers the income produced in the recovery period without considering what may occur later. This can lead to wrong investment decisions, as you can see in the following example.
The Net Present Value Method
This method saves the disadvantages of the payback period method. The distinguishing feature of this method compared to the previous one is that income and expenditure are valued differently according to the time when they occur. We define investment as the application of financial resources to purchase, renovate, or improve assets, aiming to maintain or improve the operational capability of the company. But investment has several aspects:
- The inherent risk is a factor: an investment involves a cost immediately, with the hope of revenues that will occur later.
- Make an investment only if they expect a profit. Any company has, as one of the essential objectives, to provide benefits to their owners.
- It will be carried out if it can bring more revenue than expense.
- To calculate the expected benefit of an investment and compare it with its cost, keep in mind that the costs and revenues occur at different moments in time.