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Investment activitiesInvestment activities

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Investment activitiesInvestment activities

- two possible conceptions of investments:

From the economic theory:

- capital assets, which are not determined for the immediate consumption, but for the usage in the manufacture of other capital assets

- it is a postponement of current consumption on purpose to gain higher future benefits

From the business administration point of view:

- single expended sources, which will bring financial incomes during future periods (longer than one year)

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Which formWhich formss of investments of investments do you know?do you know?

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Classification of investmentsClassification of investments

1) Tangible (material, capital) investments – make or spread production capacity of the enterprise, building of new properties, routes, buying of land, machines etc.

2) Intangible (non-material) investments – buying of technical knowledge, licenses, software,

3) Financial investments – purchase of long-term securities, borrowing of money to gain interests, dividends.

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Forms of tangible investmentsForms of tangible investments

1) Recovery investments.

2) Changes of machines on purpose to decrease costs.

3) Expansion of current production and market enlargement.

4) Development, production and sale of new product and expansion to the new markets.

5) Investments based on law requirements (safety at work, ecology),

6) Other investment projects.

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Forms of Forms of acquisition of of investment assets investment assets

purchase (machines, land, securities),

investment construction,

supplier (building of a production factory), own overheads cost (smaller construction changes),

financial leasing,

donation.

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Participants of investment Participants of investment activitiesactivities

1) Investors – organization, who is the customer of investment and who pays it.

2) Draftsmen – prepares a project, including budget.

3) Suppliers – realize the construction (investment activity).

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Which sources for Which sources for investments do you know?investments do you know?

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Sources for financial investmentsSources for financial investments

1) Own sources:

depreciation, profit, benefits from the sale or liquidation of tangible assets, new issue of shares or contributions of co-partners.

2) External sources:

loan for fixed assets, issued bonds, leasing, subsidies from state or regional budgets.

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Valuation of investments Valuation of investments effectivenesseffectiveness

- comparing of input of capital invested (expenses on investment) with benefits (incomes), which the investment brings

Crucial criteria for investment valuation: profitability (rate of return) – relationship between profit

(cash flow) and costs for its acquisition and running, risk – degree of danger, that we will not receive expected

benefits, liquidity (payback period) – period of transformation of

investment back to cash form.

Ideal investment: high rate of return, without risk and highly liquid.

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Procedure of investment valuationProcedure of investment valuation

1) Find out of capital expenses for the investment.

2) Estimation of future net cash flow, which the investment will bring; and also risk with which are these investments connected.

3) Selection of suitable criterion for valuation of investment effectiveness.

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Capital expenses for investmentCapital expenses for investment

Investment costs

expenses for the acquisition of land, buildings,

machines and equipment.

expenses connected with the sale and liquidation of

fixed assets,

expenses for project documentation,

expenses for research and development connected

with the investment,

expenses for the training of employees,

increase of the net working capital.

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Expected cash incomesExpected cash incomes

- expectation of income flow from suggested investment is more difficult than finding out of capital costs, because on income act many factors (like inflation, changed conditions on the market) and their influence is very difficult to say and expect

Total cash income structure is:

net profit,

depreciations,

income from the sale of equipment after its finished

service period.

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Methods of Methods of investment investment valuation valuation

1) Static methods – they not include factor of time:

payback period,

return on investment (ROI),

accounting rate of return (ARR).

2) Dynamic methods – they accept factor of time:

net present value (NPV),

internal rate of return (IRR),

discounted payback period,

index of profitability (IP).

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1) Static methods of investment valuation

= they do not include a factor of time

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1.a) Payback period1.a) Payback period

= period, in which the accrued incomes cover total capital expenses on this investment

If the incomes are each year equal, the payback period is:

= if the incomes are different in each year, then the payback period is a sum of the expected annual incomes till time when it is equal to invested costs

Rule for investments: The investment is profitable when the payback period is shorter than the life-cycle (time of service) of this investment.

investments costsTp = [years]

annual income (CF)

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1.b) Return on investment1.b) Return on investment

- ROI measures how effectively the firm uses its capital to generate profit; the higher ROI, the better.

- more generally, the income that an investment provides in a year.

Rule for investments: The investment is profitable, when the return on investment is higher than the rate of return expected by the investor.

average annual net profitROI = * 100 [%] investment costs

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1.c) Accounting rate of return1.c) Accounting rate of return

- similar to ROI, but instead of profit uses money (cash) income (profit + depreciation)

Rule for investments: The investment is profitable, when ARR is higher than the rate of return expected by the investor.

average annual incomeARR = * 100 [%] investment costs

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2. Dynamic methods 2. Dynamic methods of investment valuationof investment valuation

= they include a factor of time

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Dynamic methods Dynamic methods of investment valuation of investment valuation

- they suppose, that the value of money changes during the time - e.g. current capital 1 000 000 CZK with the interest rate 10 % p. a. will have in one year value 1 100 000 CZK, but one year ago it had the value 909 091 CZK

- all cash flow (positive or negative) have to be hold out to a suitable date (present time) and converted (discounted) to a present value

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Time value of moneyTime value of money

= m= methods to find out current value or ethods to find out current value or future value of moneyfuture value of money

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2.a) Net present value2.a) Net present value

= sum of discounted net cash flows for the whole life-cycle of the investment

CZK i)(1

CNPV

n

0tt

t

Ct cash flow from the given date for the period t

i discounted rate as a decimal number (e. g. the rate of return of an alternative investment, WACC)n life-cycle of the investment

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Rule for Investing Rule for Investing uusing NPVsing NPV::

NPV > 0 accept the investment,

NPV = 0 we achieved just expected rate of return,

NPV < 0 refuse the investment.

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2.b) Internal rate of return2.b) Internal rate of return

- finding of discount rate with which the NPV is equal to zero, it means NPV of expected incomes is equal to the present value of expenses on this investment

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Rule for investing using IRRRule for investing using IRR::

If IRR is higher than the discount rate (expected rate of return including the risk), then it is possible to accept

this investment project.

If the investment is financed by the loan, it means, that the IRR should be higher than the interest rate of this

loan.

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Rule for investing using IRRRule for investing using IRR::

IRR ≈ iL + NPVL * (iH – iL)

NPVL + NPVH

IRR > iL … OK, we accept this investment

IRR < iL … we refuse this investment

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Relationship between NPV and IRRRelationship between NPV and IRR

IRR

Discount rate (i) %

NPV

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2.c) Discounted payback period2.c) Discounted payback period

= period, when accrued discounted incomes from the investment are paid back by the discounted capital expenses

Rule for investments: Investment is profitable, if the discounted payback period is shorter than the expected life time of the investment.

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2.d) Index of profitability2.d) Index of profitability

= proportion between discounted net incomes (DNI) and discounted invested costs (DIC) of the project

Relationship between NPV and index of rate of return:

NPV = 0 ↔ IP = 1NPV > 0 ↔ IP > 1NPV < 0 ↔ IP < 1

Rule for investments: Investment is profitable, if IP is higher than 1.

DNI DIC + NPVIP = = DIC DIC

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Comparing of investment Comparing of investment options:options:

If there is more possibilities for investment of capital, then can occur 2 situations:

there is enough capital just for one investment – it is necessary to choose the most profitable option.

there is enough capital for more projects – it is necessary to decide about the sequence of projects according to their profitability.

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1) For each investment we will find out NPV, IRR, IP.

2) According to IRR (IP, etc.) we decide about the rank of investments.

Disadvantages:

we do not include time,

during the time the value of capital (discount rate) changes.

Selection from Selection from investment possibilities:investment possibilities:

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PortfolioPortfolio

- spending of capital is always risky

- it is not eligible the enterprise to invest all its free financial means to the only action

- the company should invest into various actions (shares, bonds, different firms, properties, etc.) – it should create a portfolio

Portfolio = collection of market shares and other assets (held by investor). The aim: the highest profitability, the lowest risk.

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TIME VALUE TIME VALUE OF MONEYOF MONEY

(current, future)

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Simple InterestSimple Interest we calculate the interests only from the we calculate the interests only from the

original principle (P)original principle (P)

duration of interest duration of interest << period of interest period of interest

duration of interestduration of interest = time, when our money = time, when our money (principle) is lent to a bank or to another person(principle) is lent to a bank or to another person

period of interestperiod of interest = time, for what the principle = time, for what the principle increases for the given interestincreases for the given interest

= annual, quarterly, monthly = annual, quarterly, monthly ……

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Simple InterestSimple Interest The formula for The formula for simple interestsimple interest is is::

I = PI = P * * i * di * d * (1 - t)* (1 - t) 100 360100 360

I … interestI … interestP … principleP … principlei … interest ratei … interest rated … number of days (1 month = 30 days)d … number of days (1 month = 30 days)

In order to determine any of the variables In order to determine any of the variables (I, P, (I, P, ii, t, t) you only need the other ) you only need the other threethree

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Simple InterestSimple Interest When you know three of the four values, here's When you know three of the four values, here's

how you calculate the unknownhow you calculate the unknown::

To find To find principalprincipal (P) (P):: P = P = II

(i / 100) * ((i / 100) * (dd/ 360)/ 360)

To find the To find the interest rateinterest rate ( (ii)):: r = r = II * 100 * 100

PP * * ((dd / 360)/ 360)

To find the To find the period of timeperiod of time ( (tt)):: dd = = II * 360 * 360

PP * * ((ii / 100)/ 100)

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1. How much money do I need (1. How much money do I need (PPrincipal) to get rincipal) to get EUR 18.20 at 3.25 % in 8 mths.?EUR 18.20 at 3.25 % in 8 mths.?

2. How many 2. How many daysdays will it take if I invest EUR will it take if I invest EUR 5000.00 at 5% to make EUR5000.00 at 5% to make EUR 136.136.5050??

3. 3. What is the interest rate for 9 months, when What is the interest rate for 9 months, when the principle is the principle is EUR 745.0EUR 745.00 and simple interest 0 and simple interest is is EUREUR 178.80?178.80?

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Compound Interest Compound Interest (Future Value)(Future Value)

we calculate also the interests from we calculate also the interests from interestsinterests

duration of interest duration of interest >> period of interest period of interest

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Compound Interest Compound Interest (Future Value)(Future Value)

Suppose you open an account that pays a Suppose you open an account that pays a guaranteed interest rate, compounded annually. guaranteed interest rate, compounded annually.

You make no further contributions; you just You make no further contributions; you just leave your money alone and let compound leave your money alone and let compound interest work its magic. interest work its magic.

The balance your account has grown to at some The balance your account has grown to at some point in the future is known as the point in the future is known as the future valuefuture value of of your starting principal. your starting principal.

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General formula for future value:General formula for future value:

CVCV is the principal (the initial amount you borrow is the principal (the initial amount you borrow or deposit) or deposit)

ii is the annual rate of interest (percentage) is the annual rate of interest (percentage) nn is the number of years the amount is is the number of years the amount is

deposited or borrowed fordeposited or borrowed for FVFV is the amount of money accumulated after is the amount of money accumulated after nn

years, including interest. years, including interest.

When the interest is compounded When the interest is compounded once a yearonce a year: :

FV = FV = CV * CV * (1 + (1 + i/100 i/100 * (1 - t)* (1 - t) )) nn

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General formula for General formula for currentcurrent value: value:

ii is the annual rate of interest (percentage) is the annual rate of interest (percentage) nn is the number of years the amount is is the number of years the amount is

deposited or borrowed fordeposited or borrowed for FVFV is the amount of money accumulated after is the amount of money accumulated after nn

years, including interest. years, including interest.

When the interest is compounded When the interest is compounded once a yearonce a year::

CCV = V = FV * 1 FV * 1 ((1 + 1 + i/100i/100)) nn

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a) How much money you can have at your a) How much money you can have at your account in 3 years if you deposit 15 000 CZK account in 3 years if you deposit 15 000 CZK at the beginning and the interest rate is at the beginning and the interest rate is during the whole time 3 % ( if you use during the whole time 3 % ( if you use compound interest factor)compound interest factor)..

b) How much money did you get on the b) How much money did you get on the interest (difference between the deposit and interest (difference between the deposit and final sum)?final sum)?

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c) c) How much money do you have to deposit How much money do you have to deposit to your account if you want to get 150 000 in to your account if you want to get 150 000 in 4 years for the house reconstruction. The 4 years for the house reconstruction. The interest rate of compound interest factor is interest rate of compound interest factor is 3,5 %.3,5 %.

d) d) How many % has to be the interest rate How many % has to be the interest rate (use compound interest) for the money if you (use compound interest) for the money if you expect to deposit 130 000 CZK and have after expect to deposit 130 000 CZK and have after 5 years 200 000 CZK for the reconstruction of 5 years 200 000 CZK for the reconstruction of a flat?a flat?