Syndicate
ANNEX - Methods to Select an Investment
Static methods - The static methods consider all the payments and collection that an investment has, without taking into account the moment in which it is produced. In this way, for example, a collection received in the year 1 has the same treatment as to the one received in the year 3. This circumstance simplifies the calculations, but it has the inconvenience that the results of these methods are always approximations and never exact.
The most used static methods are those of net cash flow and of payback.
- Net Cash Flow
- The net cash flow is the sum of all the collected, minus the sum of all the payments related to a determined investment, including the initial payment:
- Net Cash Flow = sum collected from investment – payment done due to
Investment
- Net Cash Flow = sum collected from investment – payment done due to
According to this method, a favorable investment will be that in which a positive net cash flow is produced. If you have to choose between several investment projects, you should decide for that project which generates a higher net cash flow.
Example A
To calculate a net cash flow of an investment that needs to do an initial payment of 5,000,000 m.u. at the beginning of the first year. The investment will generate the following sums to collect:
- 3,000,000 m.u. (at the end of the first year)
- 3,000,000 m.u (at then end of the second year)
The net cash flow can be calculated as follows:
Net cash flow = -5,000,000 + 3,000,000 + 3,000,000 = 1,000,000
Example B
It is about deciding which of the two following investment is more convenient by using the net cash flow criterion:
Sums to Collect
1st Investment 2nd Investment
Initial investment 4,000,000 4,000,000
End of the first year 0 5,000,000
End of the second year 0 0
End of the third year 5,000,000 0
The net cash flow of both of the alternatives is equal to 1,000,000, so both of the alternatives are equally advisable from the point of view of the net cash flow criterion.
The main problem of this method is that at no moment does it take into account the period of time in which payments and collections are made. Evidently, it is not the same to receive 5,000,000 in one year than in three years.
- Payback-term
- The payback term is the delay time in which the money invested is recovered. To calculate the pay back term , you have to add and subtract the different payments and collected amounts by chronological order, until the sum is equal to the amount invested. At that moment, you will have recovered the sum invested.
Among all the advisable projects, the most convenient of them all, according to this criterion it is that which has a shorter payback term.
This method has serious inconveniences:
- it does not consider what happens after the payback term, which leaves out from the analysis a very important amount of information
- according to this method, both of the projects are equally advisable if they both have the same payback term. In this way, a project with a recovering term of five years; that during the first four years it recovers a 10% of the capital invested and the other 90% is recovered on the fifth year. It is advisable as the other in which the recovering is of 90% in the first year and during the following four years the other 10%.
- The following is the solution by this method of the two examples studied when explaining the net cash flow.