Understanding Business Investments and Financial Resources
The rental income for this method is 100% tax deductible, and there is no minimum duration of the lease. At the end of the contract, the lessee company is given the option of renting equipment to replace or renew the contract for a further period to be determined. Unlike leasing, no lessee can purchase at the end of the contract.
Distinguishing Between the Cost of Outside Resources and That of Resources
Most of the resources used by the company involve a cost. The company will try to get that source of funding which involves the lowest average cost because that way the benefits from the investment made will be greater.
Cost of Own Financial Resources: Contributions from members and reserves do not represent a commitment by the company to pay certain interest or a dividend, so the calculation of the cost of resources is difficult. The partner of the firm assumes a very high risk and does so because it expects a profit to compensate for this risk. In market terms, the cost of equity can be equated with the profitability that the shareholder achieves.
Cost of Outside Resources in the Medium and Long Term: In the case of medium and long-term sources, there is always a contract specifying the conditions of the loan with interest payable. To calculate the corresponding effective cost (APR), all costs should be taken into account. Financial institutions must give the value of the APR of the loans they offer.
Cost of Outside Resources in the Short Term: Among financial sources in the short term, a distinction should be made between those requiring some form of negotiation and those that are spontaneous. Spontaneous sources (wages, money owed to government agencies) are resources that have a zero cost.
Weighted Average Cost of Funds: To determine the average cost of resources used by the company, a weighted average of different costs can be used, taking as weights the percentage that each source represents of the total financial resources used. The amount thus calculated is called the weighted average cost of funds. The smaller the average cost of resources used, the greater the number of investments that are profitable for the enterprise, i.e., they generate a profit.
What Is an Investment?
Definition: An investment is the act whereby a change of immediate satisfaction, the degree to which one renounces, is made for the hope that is acquired, for which a good support is acquired.
Example: A company invests a certain amount of money in purchasing a machine. The act of buying the machine is giving, for example, bills to pay suppliers in cash, but the company hopes to achieve with the machine revenue equal to the amount invested. The company, to carry out its activities, requires a set of elements or factors of production. For the manufacture of new products, it needs to purchase machines, buildings, transportation elements, etc. The company gets the resources it needs from the capital market. Families, businesses, and the state act as suppliers of capital, as we see in the chart below: Thanks to savings, businesses can get the resources they need to perform their investments and, hence, are eligible to obtain benefits. Therefore, to produce the investment, there must be savings.
Characteristics of an Investment
Every investment is characterized by the flow of payments and receipts generated in the company while it lasts. The financial characteristics are:
- Initial Disbursement: It is represented by D0 and is the amount the company pays when purchasing items of assets. It is called time zero and is usually the highest payment.
- Duration of Investment: This is the number of years, represented by n, during which cash inflows and outflows will be produced.
- Net Cash Flow or Quasi-Rents: These are represented by Fi and represent the difference between receipts (Ci) and payments (Pi) that the company supports throughout each of the n periods of investment as a result of the development of the project. Net cash flows are the difference between receipts and payments, and between income and expenditure.
- Income is the right of the company to be paid money, while the collection is the realization of this right, i.e., the perception of money.
- Expense is an obligation that the company incurs as a result of the implementation of a project, and the payment is the effective outflow of money as a fulfillment of this obligation.
- Residual Value: The value of the asset at the end of the investment’s life. It may happen that this value is zero when the asset has no market acceptance. It is represented by R. This value will be added to the collections of the last cash flow.
Difference Between a Static Method and a Dynamic Method
The Static Method is based on the assumption that the value of money is constant over time. It works as if the money collected at different times has the same value. These methods do not take into account the time factor; therefore, cash flows still have the same value that occurred at different times. Funds have a different value over time because of interest rates and inflation, i.e., one cannot compare €1000 today with €1000 a year ago. This is why these methods of investment selection should not be used because they can lead to wrong decisions.
The Dynamic Reasoning, however, takes into account that money has different values depending on the time when the cash flow occurs (either positive or negative). Two monetary amounts obtained at different times have different values since the money can be capitalized at a certain interest rate, and in addition, the purchasing power of money varies due to inflation. Capital C becomes a capital Cn after n periods of capitalization at a certain interest rate per period and is equal to Cn, the amount obtained by applying the compound interest formula: (formula). If you know the quantity Cn after n periods of capitalization and interest, and we obtain the equivalent n periods before, we use (formula).
The Pay-Back Method
The aim of this method is to determine the number of years it takes to recover the initial disbursement. This initial investment criterion is compared with cash flows. If all cash flows are equal: F1 = F2 = F3 = … = Fn = F, the recovery time T is obtained: T = D0 / F. If cash flows are different, T is obtained by accumulating different cash flows up to the initial disbursement.