Bolivarian Republic of Venezuela

(t— Ministry of Popular Power for University Education National Experimental

University of the Western Plains
“Ezequiel Zamora”
UNELLEZ

ANALYSIS OF CAPITAL INVESTMENTS.

Teacher:
Attorney: Yonatan Martínez

Elorza, Apure State, April 2021

 Bolivarian Republic of Venezuela
((IE— Ministry of Popular Power for University Education National Experimental
University of the Western Plains
“Ezequiel Zamora
UNELLEZ

Program: Social Sciences.

Career: Bachelor's degree in public accounting.
Sub-project: Financial Administration
Semester: VI
Module: II

ANALYSIS OF CAPITAL INVESTMENTS.

Authors :

Arguello G. Carmarys R. IQ: 27,473,374

Borjas P. Alvaro CI: 13,569,868

I.
Ceballo H. Dixmary A. CI: 27,747,927

Elorza, Apure State, April 2021

 In economics, investment is a term with several meanings related to savings,
the allocation of capital and the postponement of consumption. The term appears in
business management, finance and macroeconomics.

In the business context, investment is the act through which certain assets are
acquired with the aim of obtaining income or income over time. Investment refers to
the use of capital in some type of activity or business with the objective of
increasing it. In other words, it consists of giving up current and certain
consumption in exchange for obtaining future benefits distributed over time.

From a broad consideration, investment is any materialization of financial

means in goods that are going to be used in a productive process of a company or
economic unit, it would include the acquisition of capital goods, raw materials,
services, etc. From a more strict point of view, investment would only include the
disbursements of financial resources destined for the acquisition of production
instruments, which the company will use during several economic periods. In the
particular case of financial investment, the resources are placed in titles, securities
and other financial documents, in charge of other entities, with the aim of increasing
the available surpluses through the perception of returns, interests, dividends,
market variations or other concepts.

For the economic analysis of an investment, it can be reduced to the streams

of payments and income that it generates, each considered at the precise moment
in which it occurs.

1)- Capital Investment Analysis:

Investment is a process of accumulating capital in the hope of obtaining future
profits.

The necessary condition for making an investment is the existence of

unsatisfied demand, while the sufficient condition is that its return exceeds the cost

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of undertaking it. A productive investment will consist of the acquisition of goods
with a productive vocation -productive assets-, that is, goods whose utility is the
production of other goods.

When analyzing an investment project, it is necessary to take into account a

series of important variables, among which the following three are worth
highlighting:

• Project size
• The effect on economic risk
• The degree of dependency

2)- Definition of capital investment.

• Capital investment is a term used to refer to the money a company invests in
physical assets. It is an important concept to understand the accounts of a
company.
• Companies use capital investment in the development of a new business, or
as a long-term investment. This may be the acquisition of a new office, a new
warehouse or the renewal of machinery.
• Investments can be new physical assets or an expansion of the value of an
existing asset. The acquired or optimized asset usually fits into one of these three
categories: property, industry (machinery) or equipment.

• In company accounting, the costs of capital investments are spread over their
useful life, in a process called capitalization, unless they are used to repair or
maintain an existing asset.
• Operating expenses, that is, the short-term costs for the daily maintenance of
the company, and also the associated taxes, are applied in a given year.

2.1)- Importance of capital investment.

The term investment is one that is used to designate the act through which an

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individual, a company or even a government decides to place part of its profits or
dividends in an activity that allows it to obtain long-term profits and that prevents
that capital from being lose or waste. Investment is also understood as the
expenditure that a State must carry out in different areas such as health or
education and therefore it is not a waste but rather something important and
necessary for a population.
The importance of capital investment lies in achieving financial freedom. To
make an investment you must have financial resources (money). Investments
increase through interest, dividends, shares, appreciation of assets (increase in
value) when you have savings and the portion and duration of said savings must be
visualized before making the decision to invest and define where to use those
resources.

3)- Classification of capital investments: investments

3.1) - Investments are classified:
• Depending on what is being invested: that is, physical, intangible or financial
investments such as financial market assets.
• Depending on the duration of the investment, whether they are long or short
term. The long-term ones remain for more than a year to give power to the investor
and the short-term ones remain one year or less in the power of the investor.

• According to the direction of the cash flows; They can be non-simple when it is
normally a new business project and simple ones where profit expectations are
expected for all periods.
• Depending on the relationship between the investments, which can be
independent, substitutive, coupled, complementary or exclusive.
• Depending on the purpose or intention of the company; They can be strategic,
in renewal, in expansion or in product line.
• Depending on where the investment materializes if it is a company; research
investments, in shares, in stock, in social, industrial or commercial nature.

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4)- Productive investments can be classified into:

• Maintenance investments
• Replacement investments
• Growth investments
• Strategic investments
• Imposed investments

A financial investment involves the acquisition of financial assets; the

placement of resources in the financial market in the form of shares, bonds,
financial accounts, etc.

Often, the amount of resources dedicated to a new investment is so high that

the very survival of the company could be threatened by a failed project.

5)- Exclusive and non-exclusive.

5.1) - Exclusive investments:
There are also many businesses or projects that are mutually exclusive. They
are mutually exclusive, if the acceptance of one of them eliminates the possibility of
accepting the other businesses or projects. This means that if you have two or
more mutually exclusive projects, each of these will be "competing" against the
other businesses or projects. , since only one of them will be able to be accepted.
When you have independent businesses or projects, the net present value method
and the Internal Rate of Return method always give the same acceptance or
rejection decision for any business or project. In the case of mutually exclusive
projects, the net present value method and the internal rate of return method do not
always give the same acceptance or rejection decision for any business or project.
It is important to emphasize that in mutually exclusive businesses and
projects, the Internal Rate of Return method may select, as the best option, a
different business or project than the one that would be selected with the net
present value method. Therefore, it is important to always keep the following in

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mind: the net present value (NPV) method and the internal rate of return (IRR)
method will always give the same decision of acceptance or rejection of a business
or project, when You have independent businesses or projects. The net present
value (NPV) method and the internal rate of return (IRR) method can give opposite
decisions of acceptance or rejection of a project, when there are mutually exclusive
businesses or projects. What should I do if when I have mutually exclusive projects,
the net present value (NPV) method and the internal rate of return (IRR) method
5.2) - Non-exclusive investments:
Most companies have the opportunity to select from several capital
investment projects that are not mutually exclusive, that is, more than one of the
projects can be selected. However, the money available for investment is limited to
some sum that is generally established by management. This is commonly known
as the capital budgeting problem and has the following characteristics:

1)- There are several projects available that are independent of each other, that
is, the selection of a particular project does not prevent the selection of another
project.
2)- Each project is selected in its entirety or discarded, that is, partial investment
in a project is not possible.
3)- A budget constraint limits the total possible investment in the projects.
Additional budget constraints may be present for several years after the initial
investment is made.
4)- The objective of financial investment for the company is to maximize the
value of the investments.

Candidate projects are also likely to have non-determining cash flow

sequences and different risks associated with them. Problems that are of equal
risk, have only a budget constraint in the initial year, and have predictable cash
flows over the life of the project will be discussed in detail.

In the typical capital budgeting problem, there are several independent

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alternatives, each with an initial cost, useful life, series of annually independent
cash flows, and a possible salvage value. If any of the alternatives are mutually
exclusive, this must be specifically taken into account. Likewise, if any are
dependent, that is, they must be done in conjunction with another alternative, the
dependent components must be combined into an independent alternative.

6)- Evaluation stages.

We can consider two phases or stages of evaluation: the initial evaluation,
which includes the context evaluation and the diagnostic evaluation; process
evaluation or formative evaluation and results evaluation or summative evaluation,
also called exit evaluation.

6.1) - Initial evaluation:

The initial evaluation also includes the diagnostic evaluation, which can be
entry or prerequisites. It is at the outset when we explore the learning that the
student presents in relation to what is expected to be achieved in the course that
we are going to teach, allowing us to subsequently compare their conditions of
entry to the subject with those they present at the end of it.

6.2) - Process evaluation:

It is the systematic application of procedures and instruments to follow,
accompany and control student learning, with the purpose of reviewing the
development of the educational process to guide students at the appropriate time
and help them overcome errors.

7)- Capital investment analysis techniques.

An investment is a disbursement of money and other resources with the aim
of obtaining benefits from it, which is why investment analysis is going to be very
important to better see what happens with the investments that are made and
whether or not they are appropriate. in addition to providing information about
which are the most advisable investments. There are several investment analysis

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techniques that are divided into two important classes: static methods and dynamic
methods.

The static analysis methods are: the accounting rate of return method, the net cash
flow method and the pay-back method. Within the dynamic methods of investment
analysis we find the famous NPV (net present value), the internal rate of return or
the dynamic or discounted pay-back.

7.1) - Techniques:
• Among the techniques, the NPV is one of the best-known techniques for
investment analysis, and is derived from the sum of the updated values of all the
net cash flows expected from the project, deducting the value of the final
investment. It must be taken into account that the value of the return is higher than
the current value of the investment cost.

• The internal rate of return is the discount rate that makes the NPV equal to
zero. The investment is advisable if this rate is equal to or higher than the rate
demanded by the investor.

• The discounted or updated cash flow is a rate that uses the gross profits
before amortization of the years of the project's life, updating or discounting them
based on an interest rate.

• The accounting rate of return technique is a static method that is based on the
cash-flow concept taking into account the calculation [(profit amortizations)/years of
project duration)]/initial investment in the project. It does not take into account the
liquidity of the project, which the previous method does have.

• The net cash flow technique takes into account the sum of all collections by
subtracting all payments over the useful life of the investment project. It is the
simplest but also the least convenient or practical.

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 • The pay-back technique or recovery period takes into account the number of
years that the company will take to recover the investment, taking into account the
projects that will allow it to recover the investment more quickly. In this way, the
best project in this case is the one that returns the investment in less time.

• Each of these techniques has its advantages and disadvantages, and each of
them is an option for the company that wants to analyze its investment before
making it. They are mathematical methods that can be of great help to analyze
investments.

8)- Risk analysis in capital investments.

There is no doubt that business activity is subject to various risks that can
influence its future results in one way or another. Many of these risks are inherent
to the development of your own productive activity and are called business,
economic or entrepreneurial risks. These risks are related to the development,
manufacturing and marketing of products and services. Apart from these risks,
companies are also subject to others of financial origin, having an increasingly
greater influence on companies.

Within these financial risks we can highlight the so-called market risk,
consisting of the possibility that a company suffers losses in a certain period due to
unexpected and adverse movements in interest rates, exchange rates, stock prices
and raw materials or “commodities”.

Thus, in the case of interest rate risk, companies that anticipate having
excess cash-flow in a future period will be influenced by decreases in interest rates,
which will mean a lower return on their investments. On the contrary, companies
that have a future need for financing in the future will be subject to the risk of a rise
in interest rates that will mean a higher cost of their financing.

In the case of exchange rate risk, companies that plan a future payment in

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foreign currency will be exposed to a decrease in the currency exchange rate,
which will mean a lower income, while those that have to make a future payment
will be subject to the increase in the exchange rate. The rest of the market risks
could be analyzed in the same way.

The investor, normally one who has just entered the field of financial
business, does not take into account all the elementary factors of any financial
operation, which demand great attention from investors, who must study very
carefully their behavior against to these questions.

But what are those factors that investors, both experts and novices, should
take into account? Basically we must take into account what position we have
regarding these issues:

• The time factor: let's keep in mind that investing for one year is not the same
as investing for 10 years. The gains in the first are surely lower, but there is greater
"certainty" or less "uncertainty" about what will happen to the economy in a year's
time than in 10 years.
• The risk: Being 20 years old or 50 years old is not the same. When you start,
you can take greater risks on account of a "pending path", however when you are
close to retirement, it is best to be more conservative, in order to have the savings
to enjoy retirement.
• Available capital: It is not the same to have a net worth of a million as it is to
have a few euros.

• Risk aversion: that everyone has: There are investors who cannot bear to
see a savings account in negative territory. They cannot overcome fears or
psychological obstacles that allow them to endure "transitory losses", normal in
many operations. These people should never invest, for example, in stocks.

Then there is another series of factors that can affect our investment, this is

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the case, for example, of:

• The political, economic and financial stability of the country where we are
located.
• The financial policies adopted by the country where we are going to invest,
investing in Venezuela is not the same as investing in a tax haven.
• The security and confidence that our investment advisor offers us.
• The experience of the broker or financial advisor.
• The experience of the administrator of the fund in which we invest, or of the
administrators of the company from which we buy the shares.

And the list goes on. So as we see, there are several factors to take into
account, and not simply look for the most profitable option, in search of the
miraculous operation that will make us earn fortunes.

9)- Analysis of scenarios based on probability criteria.

Scenario analysis is a methodology that allows studying situations of risk or
uncertainty. This, when making investment decisions.
For scenario analysis, the value of the investment under different
circumstances must be calculated. That is, the profits and losses of the business
are projected by assigning different possible values to the reference variables.
These can be the price of currencies, inflation, interest rates, among others.

9.1) - Use of scenario analysis:

Scenario analysis is a very widespread resource in investment portfolio
analysis, where it is widely used as a complement to a value at risk (VAR) analysis.
This type of analysis is very common in general fields such as decision
theory, game theory or financial economics. Thus, it allows giving a value to the
different situations that may appear, associating a probability with each of them.
This type of analysis is also used in research, development of new products, design
of strategic plans and company valuations. That is, in fields where the future acts

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as an important element to take into account.
The fact that these analysis mechanisms take into account risk variables and
probabilities means that their results are taken into account as estimates. That is,
they are not considered absolute and immutable values.

9.2) - Types of scenario analysis:

There are several types of scenario analysis
• Stylized analyzes: Many variables can be changed or just one to see how
each factor individually affects a given event.
• Hypothetical events: Pose different assumptions and their consequences.
• Extreme current events: Extraordinary situations are projected.
• Stress test: It is an extension of extreme events.

10)- Study of practical cases.

Financial evaluation is a process that is based on theory and practice to
determine if an investment project will contribute to the company's achievements,
or if it will be a waste of resources. The financial evaluation aims to establish the
profitability levels of a project.

Practical case:

An investor, who usually makes investments as long as he obtains a minimum

return of 20% annually, is offered for sale a business that is in operation dedicated
to the manufacture of executive chairs.

A valuation study of the business contracted by the current owner, defined its
value in Bs. 70.000.000. The investor decides to carry out a financial evaluation
based on the historical information provided by the owner, to make the decision
whether or not to buy the business.

Historical sales data:

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 YEAR AMOUNT YEAR AMOUNT

2014 180 2018 205

2015 192 2019 215

2016 197 2020 210

2017 200 2021 216

The current production costs per unit, using the variable costing system, are
discriminated as follows:

Financial analysis – Production costs:

PRODUCTION MATERIALS LABOUR EXPENSES OF

DEAR STRAIGHT DIRECT MANUFACTURIN CUV

G

200 UND Bs. 18.000.000 Bs. 8.000.000 Bs. 4.000.000 Bs. 150.000

For each unit sold, a profit of 80% is obtained on the total unit cost (when the
variable costing system is used, the total unit cost is equal to the variable unit cost).
The production equipment has a value of $50,000,000 with a useful life of 10 years,
is depreciated on a straight-line basis and has already been depreciated by
$15,000,000. The office equipment is already depreciated and therefore its book
value is zero and it is not expected to sell for any value.

Operating expenses are $1,800,000 annually. An increase of 3.0% is

expected in all expenses and costs, which corresponds to the estimated average
annual inflation for the next 5 years. The salvage value is equal to the book value of
the fixed assets at the end of the evaluation horizon that is defined as 5 years,
without taking into account the recovery of working capital. If the tax rate is 35%,
what decision should the investor make?

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 Solution

First of all, it is necessary to make sales projections for the next 5 years,
which corresponds to the evaluation horizon of the project. The simplest way to do
them is to use the Excel spreadsheet and apply the fit line method to a scatter
graph developed in chapter 3, example 3.2, to design the fit line equation.

The structure of table 1 is built in the Excel spreadsheet

Financial analysis – Sales projection

TO b c
1 YEAR PERIOD AMOUNT

2 2014 1 180
3 2015 2 192
4 2016 3 192

5 2017
6 2018
7 2019
8 2020
9 2021
4 200
5 205
6 215
7 210
8 216

Table 1
1)- We mark the range B2:C9
2)- We click on Insert
3)- We click on Scatter
4)- We double click on chart type 3 and Excel draws the scatter chart
5)- We click on any point on the graph and with the right button we click again on
add trend line
6)- In trend line options we click on Linear, click on present equation in the graph
and on present the value of R2 in the graph and press accept
7)- Excel designs the linear adjustment equation, which in this case is: Y =
4.7738 X + 180.39, with Y = sales and X = the number of periods. Excel also
calculates R2 which corresponds to the coefficient of variation. To know how well
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the variables are correlated, we calculate the correlation coefficient (R), known R2,
and obtain a value of 0.9544, greater than 0.95, therefore, the adjustment equation
is valid to make the projections. If an R value is found to be less than 0.95, it is
necessary to look for other trend curves.

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 To make sales projections from 2012 to 2016, we apply the equation Y =
4.7738X + 180.39, in which Y corresponds to the number of chairs expected to be
sold each year and X corresponds to the number of periods. The projected sales
for each year (formatted the cell so that it appears without decimals, because the
number of chairs cannot have a fraction) multiplied by the unit sales price (PVU)
and by the total unit cost (CUT), will give us the result the value of income and
production costs respectively for each year of evaluation.

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