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INVESTMENT PROCESS IN THE FIRM, Garazi García Antruejo - Coggle Diagram
INVESTMENT PROCESS IN THE FIRM
Concept & elements of investments
investment definition
give up money now
expect greater returns in the future
Investment characteristics
ties up resources for a period
expected return > initial outlay
elements of any investment
investor (fund provider)
Investment object (what is purchased)
Opportunity cost (forgoing alternative uses of capital)
Reward/return
Net cash flows (NCF) = inflows - outflows each year
Classification of investments
according to purpose
replacement investments
Replace obsolete/old equipment
e.g. Replacing computers, truck fleet renewal
Innovation /modernization investments
improve technology
launch new products
automate processes
expansion investments
increase firm size
buy machinery, open brunches, build warehouses
strategic investments
Strengthen market position
E.g. EV development, renewable energy projects
according to relationship between investments
complementary investments
one investment requires another
E.g. nespresso machine + capsules
Substitute investments
Choosing one excludes other
E.g. buy a Mercedes or Volvo truck
independent investments
no influence on each other
e.g. Launching a product line vs. Implementing software
Steps for selecting investment projects
Step 1: Identify potential projects
from marketing, production, IT, logistics, etc.
Step 2: Evaluate which projects are acceptable
Profitability criteria
NPV
IRR
Strategic criteria
alignment with long-term goals
Step 3: Seect optimal combination
based on project attractiveness + available resources
Final decision
compare expected return vs financing cost
Explicit cost
interest on external funds
Implicit cost
Opportunity cost if using own resources
Calculation of cash flows (NCFs)
three evaluation dimensions
risk
profitability
Liquidity (recovery time)
structure of cash flows
investment line
Cash-flow calculation rules
revenues = collections (C)
expenses excluding depreciation = payments (P)
because depreciation is not a real cash outflow
Relationship between profit and NFC
profit: πᵢ = Cᵢ – Pᵢ – aᵢ
General NCF formula including taxes (rate T):
NCFᵢ = (Cᵢ – Pᵢ)(1 – T) + aᵢT
Final year NFC icludes liquidation value (LV)
NCFₙ = (Cₙ – Pₙ)(1 – T) + aₙT + LV – (LV − RVₙ)T
RVₙ = residual book value
(LV − RVₙ)T = tax on capital gain
Static investment selection methods
static = do not consider time value of money
main method: Payback
time needed to recover initial investment I₀
Formula (if constant NCFs)
Payback = I₀ / NCF
if NCFs vary
Add NCFs year by year until I₀ is recovered
If early NCFs are negative → add them to I₀ first
Advantages
simple to calculate
Useful when liquidity is crucial
good in environments with high uncertainty
Disadvantages
ignores cash flows after payback
ignores time value of money
no clear threshold for acceptance
Dynamic investment selecion methods
Net present value (NPV)
present value of inflows-present value of outflows
formula
NPV = −I₀ + Σ [NCFᵢ / (1+k)ᶦ]
k= cost of capital
decision rule
accept if NPV>0
if multiple positive projects
choose highest NPV
Advantages
aligned with firm objective: value maximization
considers timing of cash flows
Disadvantage
difficult to estimate k (discount rate)
Internal rate of return (IRR)
discount rate that makes NPV=0
formula
0 = −I₀ + Σ [NCFᵢ / (1 + IRR)ᶦ]
Decision rule
accept project if IRR> k (cost of capital)
IRR= relative % return
Advantages
easily interpretable
doesn’t require knowing k for its computation
Disadvantages
can produce multiple IRRs if cash flows change sign more than once
reinvestment assumption may distort results
NPV vs IRR
NPV
Absolute profitability (monetary units)
Measures value created
IRR
Relative profitability (%)
Measures rate of return
Agreement
For a single: both agree (accept or project)
Disagreement
Ranking projects may differ
NPV preferred when conflicts appear (thoretical superiority)
Garazi García Antruejo
