1 Investment activities

2 - 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)

3 Which forms of investments do you know?

4 Classification 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.

5 Forms 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.

6 Forms of of investment assets Forms of acquisition of investment assets purchase (machines, land, securities), investment construction,  supplier (building of a production factory),  own overheads cost (smaller construction changes), financial leasing, donation.

7 Participants of investment activities 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).

8 Which sources for investments do you know?

9 Sources 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.

10 Valuation of investments effectiveness - 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.

11 Procedure 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.

12 Capital 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.

13 Expected 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.

14 Methods of investment 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).

15 1) Static methods of investment valuation = they do not include a factor of time

16 1.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 costs T p = [years] annual income (CF)

17 1.b) Return on investment - ROI measures how effectively the firm uses its capital to generate profit; the higher ROI, the better.firmprofit - more generally, the income that an investment provides in a year.income 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 profit ROI = * 100 [%] investment costs

18 1.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 income ARR = * 100 [%] investment costs

19 2. Dynamic methods of investment valuation 2. Dynamic methods of investment valuation = they include a factor of time

20 Dynamic methods of investment valuation - they suppose, that the value of money changes during the time - e.g. current capital CZK with the interest rate 10 % p. a. will have in one year value CZK, but one year ago it had the value 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

21 Time value of money = methods to find out current value or future value of money

22 2.a) Net present value = sum of discounted net cash flows for the whole life-cycle of the investment C t cash flow from the given date for the period t idiscounted rate as a decimal number (e. g. the rate of return of an alternative investment, WACC) nlife-cycle of the investment

23 Rule for Investing using NPV: NPV > 0accept the investment, NPV = 0we achieved just expected rate of return, NPV < 0refuse the investment.

24 2.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

25 Rule 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.

26 Rule for investing using IRR: IRR ≈ i L + NPV L * (i H – i L ) NPV L + NPV H IRR > i L … OK, we accept this investment IRR < i L … we refuse this investment

27 Relationship between NPV and IRR IRR Discount rate (i) % NPVNPV

28 2.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.

29 2.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 = 1 NPV > 0 ↔ IP > 1 NPV < 0 ↔ IP < 1 Rule for investments: Investment is profitable, if IP is higher than 1. DNI DIC + NPV IP = = DIC DIC

30 Comparing of investment 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.

31 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 investment possibilities:

32 Portfolio - 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.

33 TIME VALUE OF MONEY TIME VALUE OF MONEY (current, future)

34 Simple Interest we calculate the interests only from the original principle (P) we calculate the interests only from the original principle (P) duration of interest < period of interest duration of interest < period of interest duration of interest = time, when our money (principle) is lent to a bank or to another person period of interest = time, for what the principle increases for the given interest = annual, quarterly, monthly … = annual, quarterly, monthly …

35 Simple Interest The formula for simple interest is: The formula for simple interest is: I = P * i * d * (1 - t) I = P * i * d * (1 - t) I … interest P … principle i … interest rate d … number of days (1 month = 30 days) In order to determine any of the variables (I, P, i, t) you only need the other three In order to determine any of the variables (I, P, i, t) you only need the other three

36 Simple Interest When you know three of the four values, here's how you calculate the unknown: To find principal (P): P = I To find principal (P): P = I (i / 100) * (d/ 360) (i / 100) * (d/ 360) To find the interest rate (i): r = I * 100 To find the interest rate (i): r = I * 100 P * (d / 360) P * (d / 360) To find the period of time (t): d = I * 360 To find the period of time (t): d = I * 360 P * (i / 100) P * (i / 100)

37 1. How much money do I need (Principal) to get EUR at 3.25 % in 8 mths.? 1. How much money do I need (Principal) to get EUR at 3.25 % in 8 mths.? 2. How many days will it take if I invest EUR at 5% to make EUR ? 3. What is the interest rate for 9 months, when the principle is EUR and simple interest is EUR ?

38 Compound Interest (Future Value) we calculate also the interests from interests we calculate also the interests from interests duration of interest > period of interest duration of interest > period of interest

39 Compound Interest (Future Value) Suppose you open an account that pays a guaranteed interest rate, compounded annually. Suppose you open an account that pays a guaranteed interest rate, compounded annually. You make no further contributions; you just leave your money alone and let compound interest work its magic. You make no further contributions; you just leave your money alone and let compound interest work its magic. The balance your account has grown to at some point in the future is known as the future value of your starting principal. The balance your account has grown to at some point in the future is known as the future value of your starting principal.

40 General formula for future value: CV is the principal (the initial amount you borrow or deposit) CV is the principal (the initial amount you borrow or deposit) i is the annual rate of interest (percentage) i is the annual rate of interest (percentage) n is the number of years the amount is deposited or borrowed for n is the number of years the amount is deposited or borrowed for FV is the amount of money accumulated after n years, including interest. FV is the amount of money accumulated after n years, including interest. When the interest is compounded once a year: FV = CV * (1 + i/100 * (1 - t) ) n

41 General formula for current value: i is the annual rate of interest (percentage) i is the annual rate of interest (percentage) n is the number of years the amount is deposited or borrowed for n is the number of years the amount is deposited or borrowed for FV is the amount of money accumulated after n years, including interest. FV is the amount of money accumulated after n years, including interest. When the interest is compounded once a year: CV = FV * 1 CV = FV * 1 (1 + i/100) n (1 + i/100) n

42 a) How much money you can have at your account in 3 years if you deposit CZK at the beginning and the interest rate is during the whole time 3 % ( if you use compound interest factor). a) How much money you can have at your account in 3 years if you deposit CZK at the beginning and the interest rate is during the whole time 3 % ( if you use compound interest factor). b) How much money did you get on the interest (difference between the deposit and final sum)? b) How much money did you get on the interest (difference between the deposit and final sum)?

43 c) How much money do you have to deposit to your account if you want to get in 4 years for the house reconstruction. The interest rate of compound interest factor is 3,5 %. c) How much money do you have to deposit to your account if you want to get in 4 years for the house reconstruction. The interest rate of compound interest factor is 3,5 %. d) How many % has to be the interest rate (use compound interest) for the money if you expect to deposit CZK and have after 5 years CZK for the reconstruction of a flat? d) How many % has to be the interest rate (use compound interest) for the money if you expect to deposit CZK and have after 5 years CZK for the reconstruction of a flat?