Management of company investments 1/2 (how to evaluate company investments)
Some of the important objectives and tasks of investment controlling are: assessment and prioritization of investments, optimal structure of funding sources, cooperation with financial management in tax optimization.
To meet these objectives, it’s needed to get informations from various investment alternatives, especially the planned cash flow for a specified period and the required amount of capital.
The process of investment controlling for evaluating the attractiveness of the business model
1. investment evaluation and prioritization according to the financial attractiveness
2. Selection the optimal structure of funding capital
3. analysis of the relationships: evaluate qualitative criteria, relationships between investments.
4. The final investment evaluation: The choice of investments, optimal sources of financing, taking into account other relevant aspects of financial management (see below).
Note. investment controlling process is usually part of the feasibility study
For the evaluation of investment are most commonly used static and dynamic methods:
some of the static methods take into account the time factor and not take into account risk(or alternative investments). Their biggest advantage is simplicity and speed of implementation. Examples of static methods:
– Total cash flow of investment over a specific period of time: CCF = CF [v1.roku] + CF [in 2nd year] + .. CF [n]
– Total net cash flow for a certain period of time NCCF = CCF [for a specified period] – IN; while IN is value of investment
ROI = NCCF / IN * 100 [%]
ROI state how much profit make investment for invested capital for specified period of time. Or through cost savings (cost savings = NCCF) when the investment does not directly generate profit but saves costs.
ROI can be express in %, then it says how many % of the profits (or cost savings) generates invested capital, respectively proportionately (ie. Without%) indicates how much profit (or cost savings) accounted for 1 unit(in the case of the euro 1 Euro) of investment.
If the value of the ROI during the specific time period is greater than 100% then the investment is advantageous because the benefits from investment are higher than invested capital.
payback period is a time period (eg. number of months, years) when the investment of the investor’s returns. Paybeck period can be easily calculated: express cashFlow in every selected unit of time(eg. the year).
Investment returns in the period when the sum of cash flow (CCF) = investment amount (IN).
average annual cash flow: avgCCF = CCF / n; while the n-number of years of life investment
average annual return: avgY = avgCCF / IN
the average payback: IN / avgCCF
average cash flow, average ROI
Take into account the time factor and the discount rate.
The discount rate expresses the interest rate of alternative investments, or required profitability which includes the accepted investment risk.
NPV is one of the most common and simplest of dynamic methods
NPV= -IN + DCF[v1.period] + DCF[v2.period] ..+ DCF[v n-period] DCF=CF/(1+k)^n
Interpretation: DCF express what is the current value of future income CF obtained in the n-period, bear interest at the discount rate while interest bearing are interest on the interest.
results of NPV:
If NPV >= 0 it’s worthwhile investment because investment earn more compared to other considered investment(or risk acceptance) expressed % rate over n years.
If NPV < 0 it’s not advantageous for us compared to other considered investment (or risk acceptance). Note. If we want to find out how the discount rate should be so that NPV = 0 so that we can determine the IRR calculation formula. practical example of NPV
Suppose that we decide between two investments:
1.offer is investment 40 000 eur to the agreed equity in the company, while the share in the company would generate income 10 000eur in the 1st year and 40 000euro in the 2nd year.
2.offer is investment 40 000 eur to the banking investment product with an interest rate of 5% for two years and they are not interest-bearing compound interest.
This task is transformed into the form:
NPV= -40 000 + 10 000/(1+0.05)^1 + 40 000/(1+0.05)^2 = -40 000 + 9 523.80 + 36 281.18 = -40 000 + 45 804.98 = 5804.98
Conclusion: 1.offer is preferable, because if we want to achieve the same profit in the 2.offer as in the 1.offer, then we need to now invest into bank product(ie.2.offer) 45 804.98 eur, while it’s enough to invest 40 000euro into the 1.offer.
Example of more complex dynamic method is EVA which gives the company profit which remains after payment of liabilities to creditors and payment of profits to shareholders.
Despite the benefits of dynamic methods number of surveys have shown that the more managers choose investments with negative NPV. It’s not because of ignorance but because NPV doesn’t consider changing strategy during realization of the investment. This does not mean that NPV is bad method but only with riskier investments should be considered also real options.
There are several types, such as real options. learning option (relegate decisions in the future, depending on the findings. In case the time proves unprofitable project option is not used and there is so to minimize the loss of the investor), growth options, locking options.