*Note : I am going to add my Corporate Strategy Assigment when i was at the university about Financial Investment Methods. Enjoy it :)
FULL
CORPORATE FINANCE 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).
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