Investment analysis

publication date 21.05.2008

Analysis of investment efficiency

The company´s development in its respective stages cannot do without investment.  Making the right decision as to where to invest your money and efforts is easier when you can take advantage of a financial consultant´s service, or when knowing the analysis described for your below.  

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The decision on investments is one of the strategic decisions the company´s managers are supposed to make. Investments effect the firm´s future and effectivity. They serve the company a couple of years, so they can be both a source of value increment/revenues for the company and also a heavy burden through their fixed costs. The financial theory interprets investment as a resource expended in order to gain benefits expected within a longer term. 

Investments can be as follows: 

  • capital investments (tangible and intangible) - purchases of machinery, land, projects, know-how, and the like,
  • financial investments - purchases of bonds, securities, shares in order to gain revenues. 

Naturally, at this point everybody starts wondering - is there an ideal investment? One that yeilds a high return, is risk-free and, on top of it, will be paid back quickly. Regrettably, the answer is negative, for such demands for an investment are contradictory. A high-return investment will always be risky. A low-risk investment will be paying back a long time. Now it is precisely the time for managers to decide which investment is worth „making“ and which is not. In their decision-making, they have criteria to go by.  

Criteria for making decisions about investment:

  • rate of return -  a relation between the revenues brought in by the investment while in existence and the costs incurred when purchased and while being operated
  • risk rate - a risk of failing to achieve expected revenues 
  • payback period - how fast the investment is translated back to the money form 

Process of assessing investments

The very essence of this process is comparing the invested capital (investment costs) with the revenues it is going to bring in. It is budgeting one-time costs and annual revenues during the investment´s period of existence. The return, then, is equal to the increment of net profit and depreciations (cash flow) which come back to the company in the prices of products or services sold. 

The process of assessing investment includes: 

1. Estimated one-time cost per investment.

 In machinery investment, the estimate includes the purchase price of investment property which normally comprises the purchase price plus freight, assembly and installation costs, duty and the like. Regarding the other costs, there the estimate is not so accurate, namely in construction costs, research and development costs, environmental costs, etc. 

 2. Estimated future revenues and risks.

 Profit and write-offs make the main revenue items. The calculation is based upon the estimated future sales and costs - both fixed and variable. As a rule, the investment makes inventory grow, increased sales boost receivables. Increases in both the items create a need for additional resources, the difference between an increase in short-term assets and an increase in current liabilities is defined as a change in net working capital. 

 3. Calculating cost to capital ratio of the company.

 When assessing an investment, the cost of capital has to be taken into consideration. If the company is funding the entire investment with their own capital, the cost is equal to the desired return on capital expressed as a dividend per share. If the investment is fully funded through credit, i.e. external resources, then the cost is equal to the credit interest. If the company, in this case, does not achieve the return on investment at least equal to this credit interest, it will mean they are creating a loss. In most cases, the average capital costs are used, a combination of both the resources calculated as the arithmetic mean. 

i = w u * u (1 – D s) + w u * N vk

i = average capital cost rate (company discount rate)

D s = income tax rate (%)

w = significance of individual capital components (as % of total costs)

u = % of credit interest

N vk  = % of own capital costs

 4. Calculating current value of expected return.

 There is a sizeable time lag between one-time investmnt costs and expected return which is being generated for a number or years. The time factor generally makes today´s value of money higher than its future value. Therefore, the return has to be related to the same time base, which is normally the year of purchase. The same applies to the costs, if they are being expended for longer than one year. The future value will be then converted into the current value. It is a sum of money that has to be invested, if it is supposed to be recovered at the stated time as increased by the expected return.

SH  = BH / ( 1 + i ) n

SH = current value of future revenues

BH = future value, i.e. the expected value of CF in the specified period 

   i = interest rate

  n = investment availability period 

Assessing investment effectivity - the methods

Assessing an investment as viewed from the previous course of action is still not enough. It is appropriate to be concerned with the investment effectivity. The effectivity is evaluated through the following metrics: 

 1. Net Present Value of Investment.

 To be calculated as the difference between the present value of expected cash-flow and the initial costs per investment. The net present value is regarded to be the fundamental, primary method of investment evaluation.  

 2. Internal Rate of Return – IRR.

 It is defined as a discount interest rate at which the current values of expected cash-flow from the investment equal to the current value of the investment expenses.

 3. Pay back Metod.

 The pay-back period is a period during which the future cash-flow brings in the value equalling the cost of investment. 

 4. Return on Investment ROI.

 To be calculated as the ratio of the net annual average profit to the cost of investment. 

Jana Sovová

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