Everybody thinks they know what investing is. It is the investment of money and other means in the present time, with a hope of gaining profit in the future. Sounds simple. However, do we know all we need to bear in mind?
The main features of nearly all investments are:
Long-term nature ,
Time gap between investment and its effects,
Interdependence between investing and financing,
Risk and uncertainty.
Long-term nature. Investments imply financing of long-term (fixed) assets as well as the need to ensure the necessary working capital for the functioning of such fixed assets, which leads to the long-term immobilization of significant financial assets. If long-term sources of funding for investments are not ensured, the company’s liquidity will be reduced and its operations likely jeopardized.
Time gap between investment and its effects. An investment project consists of two main parts: investment and effectuation. In the first part we invest in a project that is still not making profit. The longer the first phase lasts, the lower the cost-effectiveness of the investment project is. In the second part, after the object of the investment is enabled and generates positive cash flows (revenues in excess of expenditures), the company begins to have benefit from the investment. The benefits are measured by their range and time-dynamics. The further away the effects of investment are achieved in a more distant future, the lower the cost-effectiveness of the project is, which ultimately may lead to a level of unprofitability.
Interdependence between investing and financing. Investing in investment projects is linked to their financing, as well as to the financing of entire business operations. During the investment phase money expenditures are incurred, which will be financed by the company’s own resources or external sources, while the availability of funds must be aligned with the project dynamics. Otherwise, the investment phase will be prolonged or there will be a lack of liquidity. In the effectuation phase, the repayment deadlines must comply with the dynamics of the return on investment. Insofar as the investment effects in the given period are lower than required, the company’s business operations will once again be threatened by insolvency.
The cost-effectiveness of all these segments is evaluated through capital budgeting as a system of planning, analysis, and control of the intended investments. Its integral part is the evaluation of project cash flows in all phases (investment dynamics, inflows and outflows in the effectuation phase, loan repayment deadlines), assessment of profitability, and the valorization of all identified risks connected to the project.
Because money has its price, identified cash flows must be reduced to their present value or discounted at a rate that is defined by the cost of used capital – the rate must be aligned with the funding sources and must reflect their market price, that is, the price at which the company may obtain money for project financing.
All this needs to be incorporated in the plan of existing company business operations, given that because of their long-term nature and low liquidity, investment projects define the financial position and the company’s performance in the long run. Therefore, the careful planning of expected financial effects of the intended investment, as well as reasonable identification of risks and their quantification are key factors of a rational investment policy.
Only when we have succeeded in putting together all of the above mentioned, have we created a document called an Investment Study, which is the first step of every investment.