CHAPTER 3. Fundamentals of Investment Decision Making
3.1. Investment and financial decisions
Case: the rationale for the investment decision - the organization of the production of a cross-country vehicle in an operating automobile plant (simplified example).
The purpose of the project. At the current automobile plant, the project of organization of production of a unique environmentally safe off-road vehicle for year-round operation in the tundra and sand zones is being considered. The output to the designed capacity is expected from the first year of the project. The annual volume of production and sales is 450 cars per year. The project lifetime - 10 years - is equal to the full depreciation of technological equipment. The production is based on the use of existing production capacities, technologies and sales systems at the automobile plant.
The project initiator is an automobile plant, incorporated in 1993 (the authorized capital is divided into 5,699,268 common shares). Currently, it is quite a financially stable large corporation with a relatively stable sales market. Some of the products are exported abroad. The project in question refers to the traditional sphere of activity for this corporation and is financed from own capital.
Expected quantitative characteristics of the project. The corporation manager determined the following expected parameters related to the analyzed investment decision:
o unit price (P) - $ 35,000;
o expected annual average sales volume (e) - 450 pcs;
o capital costs (costs in the zero period for the purchase and installation of equipment, start-up, R & D, etc.) (C) - $ 10,000,000;
o standard of the current assets (in relation to the total cost, in days) (t) - 20 days;
2) current costs (including marketing costs, without depreciation):
o variables per unit of output (c) - $ 13,100;
o constant, per year ( C /) - $ 3,800,000;
o depreciation rate (s) - 10% per year;
o income tax (b) - 24%.
From the statistics of the stock market, the following data are also known:
o rate of risk-free investment in US dollars (Y /) - 5% per annum;
o market premium for the risk of investing in shares of United States companies (АЯ = /?, - Щ, USD) - 18.5% per annum;
o a non-fatal systematic risk factor for the industry "Machine and Automotive" - 0.65.
o evaluate the positive results (cash flows) of the project;
o Evaluate the normative results (the required level of profitability) for the estimated investment decision;
o Calculate the main criteria for evaluating the investment project and draw a conclusion based on their results.
3.1.1. Free cash flow
Three aspects of the financial manager's activities:
1) working capital management;
2) making investment decisions.
The long-term objectives of a financial manager include all aspects of investment and financial decisions.
By definition, investment represents a rejection of consumption of goods today in order to generate income in the future. Future incomes are obtained by investing in long-term (capital) assets that generate revenue. Hence investment decision - is the choice of long-term assets that generate revenue. In order for the asset to bring the required level of income, it is necessary to implement a certain sequence of actions in accordance with the purpose of investment, carefully justified by technical and economic calculations, called the investment project.
In the process of making investment decisions, the manager solves the following main tasks:
o a professional description of investment opportunities (alternatives) and their evaluation in terms of profitability, time and business risk;
o comparison of alternatives, choosing the best of them;
o the formation of an investment portfolio, i.e. an optimal set of projects within the expected budget (this process is otherwise called rationing of capital);
3) adoption of long-term financial decisions.
In contrast to the investment financial decision involves choosing sources of business financing, seeking funds to acquire assets that generate revenue. Financial decisions mirror the investment, they form the structure of not assets, but liabilities and equity. Accordingly, in the process of making financial decisions, the manager solves the following problems:
o description of financial opportunities (alternatives) and their evaluation in terms of profitability, time and business risk;
o comparison of alternatives, choosing the best of them;
o formation of the capital structure, i.e. optimal set of sources of capital for the company or project.
Making investment decisions. The two sides of the investment decision are risk and profitability. The investment decision is made under the influence of two factors - the project's ability to generate revenue, as well as the risk associated with its implementation. Profitability and risk are the two sides of the investment decision. Under the influence of risk assessment, the requirements to the level of profitability of the project are formed. Then the required, i.e. normative, the level of profitability is compared with the actual expected from the project, or positive, profitability, and if the latter is higher, the project can be adopted; otherwise, it is rejected. The indicator that allows direct or indirect comparison of normative and positive returns is called the criterion for evaluating the investment decision.
Financial decision as a side effect. The financial decision affects the effectiveness of the investment, because the cost of borrowed capital and the risk associated with its provision and use, affects the profitability and risk of the investment process. In itself, the adoption of a financial solution is one of the so-called side effects affecting the overall assessment of an investment project.
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