Gayos, Karina K.

A4A
Application/Essence of Financial Management topics in investment decisions

I. Time Value of Money

The time value of money is considered as one of the most important factors
to consider if you are an investor, because today’s peso is worth more than a
promised peso in the future. A peso you have today can be used to invest
and earn interest or capital gains. And a promised peso in the future might
have a lower worth today due to inflation. It is mandatory for an investor or
financial professional to know and operate the different techniques of time
value of money.

The concept of present value is to reduce the value of the future peso to its
equivalent value in current peso. It discounts future cash flow to the current
date by the average return rate and the number of periods. Thus, investors
would know how much they have to invest now to arrive at their future
desired amount. On the other hand, the future value concept is how much is
the value of your investment today some time in the future. It calculates the
future value of a current cash flow if it was invested at a specified return rate
and number of periods. Thus, investors would know if the amount that they will
be investing today will earn interest or capital gains in the future.

II. Capital Budgeting

Capital budgeting is a step - by - step process used by companies to identify
the value of an investment project. The decision to accept or deny an
investment project as part of the growth initiatives of a company involves
determining the return on investment that such a project generates. It is
thereby important because it both creates measurability and accountability.
The real value of capital budgeting is to rank potential investment projects of
a company. Any business who would seek in investing its resources on a
project, without knowledge and without considering the involvement of risks
and returns, would be held by its owners and shareholders, irresponsible and
untrustworthy.

Capital budgeting enables a company to identify the long-term economic

and financial profitability of an investment project. Moreover, since capital
budgeting designs a structured step-by-step process that facilitates a
company in developing and formulating long-term strategic goals, seeking
out new investment projects, estimating and forecasting future cash flows,
simplifying the transfer of information, monitoring and controlling
expenditures, and most importantly, creating an investment decision. There
are various capital budgeting techniques that accompany may use, this will
be discussed below.

i. Net Present Value (NPV)

NPV is considered as the gold standard analytic technique used in
financial analysis and investment decision making. The main
purpose of investing in a project is to make money in the future. A
common saying that would relate to this matter is “You reap what
you sow”, this is because investors pay now to be able to obtain
rewards in the future. So, investors need to calculate whether the
future cash flows worth exceeds the money needed to invest on it.
The NPV nets out the acquisition cost of the investment, the
decision rule is whether NPV is less than, equal or greater than 0. In
other words, this is the project’s present value less the initial
investment. The rule of thumb with the NPV method is that, projects
with positive net present values or values at least equal to zero are
acceptable and projects with negative net present values are
unacceptable (Drury, 2004).

NPV is important to investors in determining the amount that the

investment will create for the company. So, the owners or
stockholders of the company would be able to see clearly how
 much the investment project would contribute to their value.
Moreover, NPW is an arm’s length metric and is transparent, hence,
easier to explain the assumptions used by it. NPV also
counterbalances both the cost and benefits of the investment
versus the cash outflow or the initial investment, which will give
investors an arm’s length and transparent measure for capital
budgeting.

ii. Payback period

The payback period is the simplest decision-making tool. The

payback period is the time needed to recover the investment
costs. It is important in determining whether to take up the position
or project, as longer the payback periods for investment projects
are not desirable. However, the payback period disregards the
time vale of money; it is simply determined by counting the number
of years it would take to recoup the invested funds.

Payback method does not measure the overall project value, as

cash flows after the payback period are not taken into account.
Probably the payback period is best served for small and simple
investments. If the company generates healthy cash flows that
enable a project to recover its investment in a few short years, the
payback period can be a very efficient and efficient way to assess
a project. The project with a shorter payback period is selected
when dealing with mutually exclusive projects. The simplicity of the
payback period led to the method being used. Managers will
normally like to make their investment decision using a very simple
formula.

iii. Discounted payback period

It is the number of years needed to recover initial cost (cash
outflows) of a project from its future cash inflows. To calculate it,
 there needs consequentially add the discounted value of each
future cash inflow as long as the initial cost will be recovered. This
method tried to overcome one of the disadvantages of the
conventional payback calculation, which did not take into
account the cost of capital of a company. It is an improve liquidity
measure and project time risk but not a profitability measure
substitute.

The main advantage of the discounted payback period method is

that it can give some indication of liquidity and risk. The shorter the
payback period, the greater the project's liquidity, also the longer
the project, the greater the risk of future cash flows being
uncertain. The reason why many managers still prefer to use the
payback method can be traced to various reasons such as
simplicity. Managers try to avoid other assessment methods, mainly
due to the complexity built into it. The significant risk and
uncertainty that the payback method included was really of such
great benefit to the method. The investment is the long time to
generate the cash flow. Managers will therefore prefer to use a
method such as the payback method to select a project with a
shorter payback period to reduce the risk. Therefore, the
discounted payback period, incorporating the time value of
money and risk, managers and investors tend to employ these to
their investment decisions in order to calculate the number of
periods that their investment will be recovered, thus, minimizing the
risk of uncertainty.

iv. Internal Rate of Return

The internal rate of return (IRR) is the annual effective compound
rate of return for a project or investment which makes the net
present value equal to zero. To simplify, the IRR make the
investment project breakeven. Moreover, IRR ignores the external
 factors. It is mainly used to measure the profitability of investments
or projects. If the IRR is higher than the average or is more than the
cost of capital of the company, then it is worthwhile to invest on
the project. However, when there are multiple potential
investments, the project with the highest IRR should be selected.

The IRR is an important capital budgeting technique that must also

be considered, since it is a simple and a direct tool in evaluating
and communicating the value of the investment project to those
persons who are unfamiliar with its estimation details. It is also a
useful metric if there are multiple potential investments because
the higher the IRR, the more attractive it is for investors. IRR is a
decisive tool crucial in deciding whether to make an investment or
not, its simplicity will be engaging to investors, the higher the IRR the
more worthwhile an investment will be.
v. Profitability Index (PI)
The profitability index, also known as the profit investment ratio (PIR)
and value investment ratio (VIR), it implies the costs and benefits
that would be incurred and acquired if they will be investing to a
particular project. A profit index of 1 shows breakeven, which is
regarded as an indifferent result. If the outcome is below 1.0, you
do not invest in the project. If the result exceeds 1.0, you invest in
the project.

This would be useful in making investment decisions since it is a tool

in ranking projects which allows investors in quantifying the amount
of value created per unit of investment. It considers the time value
of money at the same time it is consistent with shareholder wealth
maximization, thus, advantageous to investors.

III. Cash Flow Estimation

 Estimating the cash flow is the most important part of the capital budgeting
process. The estimation of cash flow is a must when evaluating investment
decisions of any kind. There are various cash flow estimation principles such
as the consistency principle, separation principle, post-tax principle and
incremental principle. A cash flow allows one in creating a cash flow forecast
that will help in determining where the company would borrow or get money
and at the same time how the company will pay for the expenses that will be
incurred. Cash inflows arise from financing, operating and investing activities,
whilst cash outflows results to expenses.

The estimation of cash flows is very important to investors because this will
help them in determining whether there will be enough cash to invest or pay
for the expenditures that would be incurred in the project. Cash flow is very
important in a business, because cash is the lifeblood of any conceivable or
existing business for the continuity of a business operation or survival.
Moreover, these cash flow projections will identify potential deficiency in cash
balances, determine possible problems that might occur and helps ensure
that the company have enough cash to pay suppliers and employees. From
this we could infer that cash flow estimation is really challenging and
important, they establish plans and solutions to make sure that there are
enough resources for their investments.

IV. Risks and Options

i. Risks
Risk is the chance that each future period’ cash flow will take on a
value significantly different from the expected value. Some risks
related in capital budgeting are market risk, stand-alone risk and
currency risk. There are various ways in measuring and preparing to
compromise with risks. First is conducting a sensitivity analysis, as
well as uncertainty analysis and scenario analysis. Subsequently, risk
aversion is a concept which addresses how people or investors will
react to a circumstance with uncertain result. It is the hesitation of
 investors to invest on a bargain with an uncertain payoff rather
than on a bargain with a more certain payoff. The company’s
management can implement different viewpoints based on how
risk averse they believe they should be, given distinctive market
aspects and firm situations. On the other hand, if they are more risk-
loving, they will be attracted to the riskier capital investments that
they believe have a chance for higher payoffs.

Assessing risks is a must for every investor or company, it is an

imperative to identify and prepare for potential unfavorable events
that could disturb core investment projects or business plans. With
today's market uncertainty and the unknown uncertainty of the
future, protecting and securing the company with expert insights
into investment results is simply the intelligent way to do business. It
is important for investors to assess the risks on the investments they
are about to make, this is to make sure that they will have a certain
and positive payoff rather than an uncertain payoff.

ii. Options
An option is the capacity or the right but not an obligation to
adopt a certain course of action. However a real option represents
those that occur in a real physical business sense, underlying assets
are physical and human assets are rather than financial securities.
In real option, the option to delay an investment on a project may
allow the company to evaluate supplementary information
regarding demand or costs. Another aspect of real options that
creates value can be found in abandonment, this is the option to
discontinue a project either by shutting down completely or by
switching on alternatives.

Real options are crucial in investment decisions. Investors or

companies must be knowledgeable about real options since they
 value the ability to invest now and make subsequent investments if
the project turns out to be a success and they also values the
ability to abandon the project if it turns out to be a failure and lastly
as mentioned above, real options values the ability to wait and
learn, resolving uncertainties before making a huge investment.
Having the option to invest or not will be beneficial to an investor in
contemplating whether to make subsequent investments,
abandon an investment or to wait and study a potential
investment, this will reduce or avoid losses from such investments.

V. Cost of Capital
As what previous lectures have been mentioned, there are costs under the
cost of capital namely the cost of debt (before and after-tax), cost of
common stock, cost of retained earnings, cost of preferred stock and
weighted average cost of capital. Cost of capital is the required return to
make a capital budgeting project; it is employed by companies to internally
assess whether a project is worth the amount of expenditures and resources,
or by the investors who often use it to judge whether an investment is worth
the risk compared to its return.

Costs of capital can be used widely as the measuring tool for the adoption of
an investment project proposal. It is used in discounting cash flows under NPV
method for investment proposals. Moreover, cost of capital is important and
useful in the evaluation of the financial performance of the top
management. The expected and actual cost of capital is compared to the
actual profitability of the company and if profit is greater than the cost the
performance may be said as satisfactory. Lastly, this will be important for
investment decisions since cost of capital evaluates the new project and
allows easy calculations that will provide minimum return that an investor shall
expect.
VI. Working Capital Management
Working capital is the difference between the company’s assets and
liabilities. It serves as a measure on how efficiently a company is running and
how financially stable the company is in the short-term. The indication of
good management of a company is its capacity to employ working capital
management to sustain a strong balance between growth, profitability and
liquidity. Working capital is a necessity to every business or company, to be
able to meet their obligations, cover unplanned costs and acquiring
materials to be used for production. It is a reflection of the results of different
company activities such as revenue collection, debt management, inventory
management and payments to suppliers.

It maintains an adequate balance between current assets and liabilities of a

company, an effective working capital management assists the company
not only to cover obligations but also in boosting their earnings. Working
capital management is a vital part of investment decisions, this is because an
effective management could attract new investors. So if an investor would
like to invest in a company, it is proper and vital to look on the working
capital ratio if the company is liquid to meet its obligations in the short-term.

VII. Leverage