Corporate finance involves several areas, including the choice of investment. The latter aims to determine which investments are the most profitable. To do so, one needs to choose among different alternative investments. In market finance, investment choice refers to the valuation of assets in order to define the allocation of resources.
The principle of investment choice
Investments relate to economic choices that result in projects. Therefore, to launch a project, it is important to ask questions, particularly about the choice of means, i.e. what type of investments will be suitable. The investments must then succeed in creating value. This means generating a rate of return that is higher than the opportunity cost of capital. If the investment produces value, then it will enrich the financiers, but if it does not, it will impoverish them.
The investment choice process
To make an investment choice, proceed as follows:
- Identify the investment;
- Define the flows specific to the investment (investment cost, cash flow, its life span, the end-of-life flow which includes revenues or expenses when the use of the investment is coming to an end) ;
- Use of investment selection criteria (payback, net present value and Internal Rate of Return and profitability index);
- Sensitivity analysis of the results by running various scenarios;
- Decision making.
By following this basic approach, you can be sure that your investment will be successful. But in principle, everything is based on the criteria for choosing an investment.
Criteria for choosing an investment
In order to measure the relevance of an investment choice, it is essential to assess the costs as well as the benefits it will create in the future. This requires the realization of cash flows and, at the same time, an assessment of the profitability criteria, as well as a consideration of the risks that may be associated with the investment. All of this must take into account all current knowledge.
In order to make an assessment of the relevance of an investment, four investment selection criteria should be used:
- Net present value (NPV): this is a measure of the value creation brought by the investment:
- The internal rate of return (IRR): it is used to determine the actuarial rate of return of the investment that will cancel the NPV;
- The profitability index (PI): it is a criterion that makes it possible to reflect the discounted income per unit of capital invested.
- The payback: it helps to define the moment when liquidity is recovered in order to make a new investment.