*Note : I am going to add my Corporate Strategy Assigment when i was at the university about Financial Investment Methods. Enjoy it :)
FULL
CORPORATE STRATEGY
CONTENTS
1. EVALUATION
OF INVESTMENT PROPOSALS....................................................3
2. ECONOMIC
EVALUATION.................................................................................4
3. FINANCIAL REVIEW & DYNAMIC METHODS......................................................4
4. THE
INVESTMENT DECISIONS AND PROCESS MAKING....................................5
5. THE PAYBACK METHOD..................................................................................7
5.1 DISADVANTAGES, THE PAYBACK
METHOD.......................................................7
5.2 ADVANTAGES, THE PAYBACK
METHOD............................................................8
6. THE ACCOUNTING RATE OF RETURN (ARR)....................................................8
6.1 CALCULATING
(ARR)........................................................................................8
6.2
EXCLUSIVE PROJECTS MUTUALLY & ARR........................................................8
6.3 THE ADVANTAGES & DISADVANTAGES, ARR
METHOD.....................................9
7. THE NET PRESENT VALUE METHOD
(NPV)......................................................9
7.1 THE
ADVANTAGES & DISADVANTAGES, NPV METHOD....................................10
8. THE INTERNAL RATE OF RETURN
(IRR)...........................................................11
8.1 GRAPHICAL APPROACH..................................................................................12
8.2 INTERPOLATION METHOD................................................................................13
8.3 THE ADVANATAGES & DISADVANTAGES, IRR
METHOD....................................14
9 TAKE
RISK INTO ACCOUNT IN PROJECTS........................................................14
9.1 CRITERIAS IN INVESTMENT DECISIONS...........................................................15
10 RISK MEASURES..............................................................................................19
11 REFERENCES..................................................................................................22
FINANCIAL
INVESTMENT METHODS
1. EVALUATION OF INVESTMENT PROPOSALS
Evaluation
of investment proposals is a kind of act of project preparation phase after review
process. It is possible to be made a good choice by comparing the business
objectives of one project or few projects.
Valuation of
an investment proposal should be made finacially in order to determine the
level of profitability and the degree of economic aspects.
Business
must evaluate the projects to make a choice between alternative uses of
resources and to consider resources for investment in purpose - built to be
able to give the best results. In practice, business use different methods
while they are choosing investment projects.
We can
gather these used methods in two main groups, even though they have different
features and much more numerous. In order to investors, investment projects are
generally accepted as the order of two basic classes that static methods and
dynamic methods.
- Economic Evaluation
- Commercial Profitability Analysis
- Social Profitability Analysis
- Financial Review
- Static Methods
- Dynamic Methods
2. ECONOMIC EVALUATION
Aims to
maximize social welfare, the shadow prices corrected by social aspects are
used. Shadow prices used in economic analysis are corrected to include the
effects of the savings and investments on the projects.
Economic
analysis is purposed to economic activity by receiving data to provide income
distribution and seek to maximize the income.
However,
social analysis is targeted to maximize social welfare and the assumption that
project benefits are harvested from the consumption of manufactured goods or
services value to different individuals or in terms of different income groups.
3. FINANCIAL REVIEW & DYNAMIC METHODS
All
expenditures made for investment projects, investment costs, operating costs,
completion and renovation costs usually do not occur within a year, they occur
piece by piece at various times in the economic life of the project.
Similarly,
the expected revenue flows will be charged step by step in the economic life of
the project. In addition, we know that a unit of the revenue will not be the
same value with a unit cost, which obtained different times. Then, the
resulting revenue and costs in different periods are reduced similar and
homogeneous for a specific period. According the dynamic evaluation methods,
revenues, all the costs be taken into account and the scrap value are estimated
during the economic life of the project. Therefore, to predict the cost series,
yield series in this period and the economic life of the project would be
obtained. It is clear that not easy to estimate this. Because cash inflows and
outflows is not enough just to predict the global level, it is necessary to
estimate the needs in the course of their periods.
The main
feature of the dynamic methods used in valuation of investment projects for
investors that to consider the calculations time value of money. The plain
meaning of the time value of money, the revenue that is at the provided capital
in the process cycle or that should be used to collect an undue cost
What is the
importance of taking into account of the time value of money to invest?
Expenditures
for the investment project and financial revenues in the useful life of the
investment are calculated by taking into account of the time value of money. It
is necessary to reduce the same level of investment related cash inflows and
outflows to make a meaningful comparison. On the other hand, all the countries
of the world more or less in the presence of inflation at the real value of
money require the calculation over the long-term investments.
The main dynamic valuation methods are:
·
Net Present
Value Method ( NPV )
·
Payback
Period
·
The
accounting rate of return ( ARR )
·
Internal
Rate of Return ( IRR )
·
4.
THE
INVESTMENT DECISIONS AND PROCESS MAKING
The
investment decision-making process has different levels, they are:
STARTING POINT OF PROPOSALS:
It is necessary
to prepare free brain storming places for our organizations future. New and
good ideas will grow up while employees feel free themselves to improve present
or new ideas. Some alternative projects will abandon before they start but some
of them will investigate deeply.
SCREENING OF A PROJECT:
Before
financial analysis, there has to be detailed project investigation. The ideal
projects have the same long term objectives with the organizations goals. Then,
be sure to check all the alternative projects. On condition that the project
passes this first focus after then, detailed financial analysis can start.
INVESTIGATION AND ACCEPTANCE:
This is
financial analysis level of investment decisions. In this step, investment
appraisal methods have to be considered. In addition, qualitative subjects need
to be estimated before decision-making and implementation.
MONITOR THE PROJECT:
All projects
have total costs. For this reason, Organisations separate capital to spend for
the projects. However, they have to ensure that not to spend more than the
capital. After all of these steps, if the project implement properly,
organizations will obtain the benefits that expected.
5.
THE
PAYBACK METHOD
Payback
method usually use for the first screening of the projects. When we investigate
the projects, we need to examine these questions at first:
- How long will its pay back
period take after the cost of the project?
- Is there any payback time on
target? Because it will show the acceptance of the project. If its payback
time is more than their estimates, the organization can refuse the
project.
- On the other hand, there is
no only pay back period to estimate the investment appraisals. Payback is
the first step to examine the process. If you know the pay back period, it
will help you to evaluate more detailed project appraisal methods.
- Calculation time of payback
period is very important because we need to calculate the cash returns of
projects and have to know profits before the depreciation. Calculation of
cash flows
5.1 DISADVANTAGES,
THE PAYBACK METHOD
There are
some disadvantages of payback method as below:
- Payback method denies the
cash flows timing during the period.
- At the end of the payback
period, method does not accept the cash flows. Therefore, the total
project goes back.
- Payback method denies the
money’ time value.’ More complicated appraisal techniques require’. As a sample, 1 pound’ worth will be more
than 1 pound for a year. That is why organization or money owner has to
use the money immediately or can invest the money by using current
interest rate to get more return one year later.
- This technique also does not
differentiate between projects in a same payback time.
- Investors make cut off at
the payback period randomly.
- One of the disadvantages of
payback period is to cause too much investment projects in short term.
- The risk of the cash flow
timing is projected however; variability is not estimated at the projects
in payback method.
5.2 ADVANTAGES, THE PAYBACK METHOD
The main capital of the investment is reserved at
the payback method.
- Sometimes payback can
increase liquidity if it is before the time.
- While payback period is more
than its time, there can be investment risk.
- Most of time, short term
predictions are more trustworthy than long term.
- Payback period calculation
is rapid and easy.
- Payback method is clear and
simple to understand.
6. THE ACCOUNTING RATE OF RETURN (ARR)
6.1 CALCULATING (ARR)
The
accounting rate of return method (ARR) is used for increasing the success and
yield of the investment projects. If the project surpass their rate of return
(ARR) expectations, it can be satisfactory.
The
formulate ARR is established on initial investment or else average investment.
This investment technique applies the profits of the project as an alternative
of cash flow.
6.2 EXCLUSIVE PROJECTS MUTUALLY & ARR
In this
method, Average Rate of Return is useful to compare few different projects.
If one of
the project has higher Average Rate of Return, the organisation will select that
project. Only reason is that new ARR has to be bigger than the expected ARR.
6.3 THE ADVANTAGES & DISADVANTAGES, ARR METHOD
The ARR has
some disadvantages which are related with the project profits timing. The
capital is reserved until starting the project to get more benefit. Investors
have to be awake of the advantages of before the time repayments that will use
for other projects.
Some other disadvantages are as below:
- Profits are more important
than the cash flows for ARR method.
- This method prefers the
relative measure than the absolute.
- The ARR technique deny the
money value timing
In addition, some advantages:
- Easy and clear method to apply
- Financial statements help to estimate the
profits
- The ARR method is effective in all life
of the project
- The ARR technique is based on the profit
concept; therefore, it is clear to understand the benefits of the
appraisal method for workers.
- It is easy to match and compare more than
one project in this method.
7. THE NET PRESENT VALUE METHOD (NPV)
Especially in the project
analysis, NPV is one of the most commonly used methods. NPV method is the
difference between the reduced values and a certain rate of reduction of pre-agreed
investment expenditures and provided net cash inflows in the life of the
project.
According to this method to
accept a project, net present value (NPV) must be greater than or equal to
zero.
Alternatively, the biggest
project in the net present value (greater than or equal to zero provided that)
are given priority for the selection of projects.
NPV is obtained from
receipt of the sum of all values in the present value method.
Discounted
cash flow (DFC) method is aimed to find the cash flow’s NPV.
- Profitable: if the result is positive, it shows that we
will get profit.
- Lost: If the result is negative value, it shows that investment expenses will be higher than indicative of returns.
DISCOUNT RATE AT NPV
7.1
THE
ADVANTAGES & DISADVANTAGES, NPV METHOD
Some of the advantages of
Net Present Value is as below:
- Evaluation of investment projects, it is
important that to consider the time value of money in the calculations.
This aspect gives a particular advantage to NPV method.
- NPV method, it has great importance to calculate the discount rate for
further calculation that the present value determination.
- To be low or high of this rate affect the decision of the investment
projects.
- If this rate is determinated high, large cash inflow investments will
be prefered at the beginning years of the project life.
- If this rate is determinated low, Large cash inflow investments will
be preferred at the end of the project life.
- The determined and used discount rate at the NPV method is used
without changing in the useful life of all revenues.
- However, affecting the determination of pensionable discount; resource
cost, profit rate, the interest rate in the economy and so
on. factors would be changed in a time. Therefore, for a long period
of time with a single discount rate reduction decision-making process can
be accurate in some cases blocking properties.
- Each year, with different discount rates to calculate NPV is difficult
to estimate as accurately as the rate of discount for each year is also a
hassle.
- NPV method of investment projects over a certain discount rate, are intended to maximize the present value.
8.
THE
INTERNAL RATE OF RETURN (IRR)
Internal rate of return is
a kind of method, which considers the time value of money to find the yield of
the project.
Internal rate of return is
the discount rate that the useful life of the investment cash flows will be
provided to equal throughout investment expenditures.
Internal rate of return method
consider the expected future cash flows while present cash flow is used, income
tax effect that changes from year to year, the accounts can participate in the
salvage value at the end of the useful life of the project. The amount of
direct investment is calculated with ultimately in the figure by comparing the
internal rate of return.
8.1
GRAPHICAL
APPROACH
The best way to calculate
the IRR to solve the NPV of the project with cost capital and discount rate.
NPV is at the zero level in the graph to find the discount rate.
Step 1: Make NPW profile.
Step 2: Find the value of the
interest rate that the line intersects the X-axis
8.2
INTERPOLATION
METHOD
Especially for capital
projects, if the project begin with ( - ) cash flow, then, ( + ) cash flow is
seen at the end, the NPV of project can be calculated by using graph which is
drawn with this method.
8.3
THE
ADVANATAGES & DISADVANTAGES, IRR METHOD
- Internal profitability rate method, the
investment projects that consider account the time value of money is a
dynamic method. For the reason that IRR do not have the drawbacks as the
static methods in this direction.
- The IRR is a method, which evaluate the time
factor and the useful life at the investment projects. In addition, it
estimates that the cash outflows and inflows provided the investment are
compared each other by reducing at the same time level by IRR method.
- One of the other features of this method is to
help to decide the rational investment especially in high inflation rates
countries.
- The reason for that It includes the all
investment expenditures and the all useful life of the investment incomes,
it helps to get more healthy decisions.
- Sometimes, Internal rate of return method
helps to prefer the projects, which have the useful life of the investment
projects in a short but high profitability rate in spite of long useful
life, whereas a lower rate of return.
- Years as the investment income is provided by
the continuous cases, there is no problem in the calculation of internal
rate of return.
- However, as some situations that there is no
income and only cash-out at certain times, serious difficulties can be
encountered to calculate the IRR, in some cases may not be possible to
calculate the internal rate of return.
9
TAKE
RISK INTO ACCOUNT IN PROJECTS
While the investors try to
decide project appraisals, they consider the inputs values and discounted rate
to accept or else refuse the projects. However, the most important point is to
think NPV if positive or negative, correspondingly.
After then, investors have
to find the highest NPV to decide the best option, if NPV is positive.
Nevertheless, there is
always a risk at the application. For this reason, they have to consider the
criteria of investment by distributing NPV respectively.
There are two main topics
to check while doing risk analysis. First, combination of NPV. Second,
selecting the discount rate then, use the criteria.
9.1 CRITERIAS IN INVESTMENT DECISIONS
The discount rate and the risk premium
Another important element
of time is uncertainty, namely risk. Because there is always the
possibility not to pay the borrower's debt and this danger increases with
prolonged maturity. The risk grows with time period between the two grows
larger the risk. If the risk grows, the time value of money will grow.
Making a huge factor in the
financial sector is loan funds loss because of the time value and techniques to
compensate for the risk faced by the search for financing.
An enterprise value of
discounted cash flow method, the selection is very important in determining the
appropriate discount rate.
In determining the discount
rate, the sector's characteristics, competitive factors such as cost of capital
are used in businesses.
Discounted cash flow
method, as the discount rate used is usually the cost of capital.
Decision criteria
Is difficult to predict
future cash flows will provide a business, it can not be fully predicted.
While the company's estimated
future cash flows, current cash flow and previous year’s cash flow are both
investigated together.
While in past years and
projected future status of the current year the business is used as the
indicator.
However, when estimating
the cash flows related items must be projected to the future after the
necessary corrections.
Interest coupons printed on
the Bonds. Therefore, the security of the data created by the net cash flows,
do not have to guess.
On the other hand, there
are some critical subjects, which have to be examined at the decision of the
projects. These situations follow as figured below. Situations 1, 2 and 3 are
only to consider the single project. Situations 4 and 5 are for critical decision
to select alternative investment projects, which are mutually exclusive.
Situation 1:
Situation 2:
Situation 3:
Situation 4:
Situation 5:
10 RISK MEASURES
Expected value
Value is caculated by using
Market interest rates on the value of the investment return of an investment
over the period provided by or their interest rate is discounted by as a result
of the reduction.
It is different that a
certain promise of money or a commodity to be derived later and today have been
acquired. Because this is a kind of financial model, which say the money will
lose value in intermediate-term.
The most widely used method
of evaluation of investment projects during the net present value method.
As a sample, we can explain
the expected value with the calculation as below. The expected value is 2.0 in
this project.
Cost of uncertainty
Another important element
of time inherent in the monetary matters of uncertainty, namely risk. Because
there is always the possibility not to pay the borrower's debt and extending
the maturity of the danger increases in line with this case.
Expected loss ratio
This formula includes the
absolute value of the loss divided which is expected. The total expected gain
and absolute value that loss expected help to use this formula.
Coefficient of variation
Conditions of limited liability
11
REFERENCES
H. Bierman and S. Schmidt (1971), “The Capital Budgeting Decision”
(McMillan Press, third edition).
R. Brealy and S. Myers (1991), “Principles of Corporate Finance” (McGraw
Hill, fourth edition).
Graham Glenday (1989), Monte-Carlo Simulation Techniques in the Valuation
of Truncated Distributions in the Context of Project Appraisal (Harvard
Institute for International Development).
C. J. Hawkins and D. W. Pearce (1971), “Capital Investment Appraisal”
(MacMillan Press).
David B. Hertz (1979), “Risk Analysis in Capital Investment”, Harvard
Business Review, 57(5), September-October.
David B. Hertz and Howard Thomas (1983), “Risk Analysis and its
Applications” (John Wiley and sons).
David B. Hertz and Howard Thomas (1984), “Practical Risk Analysis” (John
Wiley and sons).
Glenn Jenkins and Arnold Harberger (1991), “Cost-Benefit Analysis of
Investment Decisions” (Harvard Institute for International Development).
Donald R Lessard (1988), “Risk-bearing and the choice of contract forms for
oil exploration and Development”, The Energy Journal, 5(1).
James T.S. Porterfield (1965), “Investment Decisions and Capital Costs”
(Prentice-Hall).
For more informations:
