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TOPIC 9 --THE INVESTMENT PROCESS IN THE FIRM - Coggle Diagram
TOPIC 9 --THE INVESTMENT PROCESS IN THE FIRM
9.1. Concept and Elements of Investments:
Investing = committing resources (usually money) today to obtain greater financial returns in the future.
Investment = tying up funds for a period -> expected results must exceed the money immobilized.
Elements of any investment
Investor -> person/firm providing the funds
Object of investment -> what is being acquired
Opportunity cost -> return sacrificed by not using the money elsewhere
Reward / return -> profit generated
Net Cash Flows (NCFs) -> difference between annual cash inflows and cash outflows
9.2. Classification of Business Investments:
A) According to purpose:
Replacement investments
Replace obsolete or worn-out equipment
Examples: upgrading computers, renewing car fleet
Innovation / Modernization investments
Improve processes or product range
Examples: automation, launching new product
Expansion investments
Increase firm’s capacity or size
Examples: new machinery, warehouse, new branch abroad
Strategic investments
Strengthen competitive position
Examples: car manufacturer investing in electric vehicles
B) According to relationship between investments:
Complementary investments
One investment requires or enhances another
Example: Nespresso machine + capsule development
Substitute investments
Choosing one excludes the other
Example: choosing one delivery truck brand (Mercedes vs Volvo)
Independent investments
No relationship; choice of one does not affect the other
Example: Launching a product line vs. implementing management software
9.3. Steps for Selecting Investment Projects:
Identify all potential projects
Include ideas from marketing, production, etc.
Consider any project initially feasible
Determine which projects are acceptable
Evaluate them using:
Profitability criteria (NPV, IRR)
Strategic alignment (fit with long-term goals)
Select the optimal set of projects
Consider available resources & company objectives
Choose the combination that maximizes firm value
Final decision
Compare expected return with the financing cost
Explicit cost: interest on borrowed funds
Implicit cost: opportunity cost if using internal funds
9.4. Calculation of Cash Flows Derived from the Investment:
Criteria used to analyze investments:
Profitability
Depends on:
Initial investment
Expected net cash flows
Timing of cash flows
Risk
Possibility that future cash flows deviate from expectations
Liquidity
Time required to recover investment (payback period concept)
Chronological representation of cash flows:
At time 0 → Initial investment (I₀) (negative cash flow)
From year 1 to n → NCF₁, NCF₂, NCF₃ … NCFₙ
General NCF definition:
NCFᵢ = Cᵢ – Pᵢ
Cᵢ = collections
Pᵢ = payments
Investment duration = n years
Cash flow calculation (basic formula):
Assume:
Revenue (R) = collections (C)
Payments (P) = expenses (E) – depreciation (A)
Net cash flow:
NCFᵢ = Cᵢ – Pᵢ = πᵢ + aᵢ
πᵢ = profits of year i
aᵢ = depreciation of year i
Including taxes in NCF calculation:
If project generates profits → taxes must be paid.
General formula:
NCFᵢ = Cᵢ – Pᵢ – πᵢ·T
Replace πᵢ with (Cᵢ – Pᵢ – aᵢ):
NCFᵢ = (Cᵢ – Pᵢ)(1 – T) + aᵢ·T
Where:
T = corporate tax rate
Final cash flow in the last year (n):
Must include liquidation value and tax on capital gains:
NCFₙ = (Cₙ – Pₙ)(1 – T) + aₙ·T + LV – (LV – RVₙ)·T
Where:
LV = liquidation value
RVₙ = residual book value
Tax on capital gain = (LV – RVₙ)·T
9.5. Static Investment Selection Methods:
Do NOT consider timing of cash flows
Ignore time value of money
Used mainly for liquidity-focused decisions
Main static method: Payback Period
Measures time needed to recover initial investment (I₀)
Payback calculations
Constant cash flows:
Payback = I₀ / NCF
Variable cash flows:
Add NCFs year by year until they equal I₀
If early cash flows are negative:
Add losses to initial investment first
Decision rule
Shorter payback → better
Good for:
High uncertainty environments
Prioritizing liquidity over profitability
Limitations
Ignores cash flows after recovery
Ignores time value of money
Cutoff period is subjective
9.6. Dynamic Investment Selection Methods:
Two main methods:
9.6.1. Net Present Value (NPV):
Definition:
Present value of all future NCFs minus the initial investment.
Formula:
NPV = –I₀ + Σ [NCFᵢ / (1 + k)ᶦ]
Where:
k = discount rate (cost of capital)
Decision rule
Accept project if NPV > 0
If several projects have NPV > 0 → choose highest NPV
Measures profitability in monetary terms
Advantages
Considers timing
Considers all cash flows
Clear decision criterion
Disadvantages
Discount rate (k) difficult to determine accurately
9.6.2. Internal Rate of Return (IRR):
Definition:
Discount rate (r) that makes NPV = 0
Formula:
0 = –I₀ + Σ [NCFᵢ / (1 + IRR)ᶦ]
Meaning:
IRR = project’s percentage return
Makes investor indifferent (NPV = 0)
Decision rule
Accept project if IRR > cost of capital (k)
Calculation issues
For n > 2 → solving polynomial equation → need trial-and-error or interpolation
Steps:
Choose r₁ giving positive NPV
Choose r₂ giving negative NPV
Interpolate to find r*
Advantages
Easy to understand (percentage return)
Can compare projects of different sizes
Disadvantages
May generate multiple IRRs if cash flow signs change repeatedly
May give misleading rankings vs NPV
Relies on unrealistic reinvestment assumptions
9.6.3. Comparison: NPV vs IRR:
Both agree on accept/reject for individual projects
They do NOT always agree when ranking projects
Key differences
NPV = absolute profitability (money value)
IRR = relative profitability (percentage)
NPV is considered the superior method
Decision rules
Accept if NPV > 0
Accept if IRR > k