1
Introduction
Contents
1. Investments, discounting, rates of return– introduction ............................................2
1.1. Basic definitions .....................................................................................................2
Time, risk and opportunity costs (cost of delaying the consumption). ..............................6
Investments, speculation and gambling ...........................................................................8
1.2. Classification and features of investments ..........................................................9
Place of investments in balance sheet (statement of financial position) .......................... 11
1.3. Capital investments: ............................................................................................ 13
1.4. Financial Investments .......................................................................................... 15
1.5. Types and features of investors ......................................................................... 17
1.6. How to make an investment decision: economic profit and cash flows, return
of investment, present value of investment and rate of return .................................. 18
Main criterion in investment activity ............................................................................. 18
1.7. Time value of money ........................................................................................... 19
1.8. Rates of return – measuring relative performance of investment ................... 22
1.9. Exercises .............................................................................................................. 27
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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
DISCUSSION
How would you define investment?
What examples of investment can you name?
The word 'investment' originally comes from the Latin word 'investire', which means
'to clothe'.
Investment can be defined as an intertemporal exchange of something valuable,
usually represented by cash flows.
Other definitions:
• the transformation of capital (liabilities side of the balance sheet) into assets
(assets side of the balance sheet),
1
S. Serfas, Cognitive Biases in the Capital Investment Context, Gabler Verlag | Springer Fachmedien Wiesbaden
GmbH 2011, p. 9-10.
2
N. Seitz, M. Ellison, Capital Budgeting and Long Term Financing Decisions, Thomson. South-Western, 2005, p.
14.
3
E. F. Brigham, J. F. Houston, Fundamentals of Financial Management, 11th edition, Thomson South-Western,
Mason, 2007, p. 6.
2
Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
3
Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
Environment Society
Governance
There is no law or legal principle that could make directors and managers so loyal to
shareholders that they would serve their interests unquestionably, the management
team should be free from any shareholder constraints and be encouraged to become
servants of the community instead (Dodd 1935)
ESV is a hybrid approach which, while retaining the shareholder primacy paradigm,
requires long-termism and promotes welfare for all the stakeholders
(Fisher 2009).
4
S. Andreadakis Enlightened Shareholder Value: Is It the New Modus Operandi for Modern Companies?, S.
Boubaker et al. (eds.), Corporate Governance, Springer-Verlag Berlin Heidelberg 2012, pp 415-432
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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
2. Risk
Risk is one of central characteristics to investment. If you delay your consumption in
hope for future benefits, some level of risk is always involved.
Certainty: Perfect certainty arises when expectations are single-valued: that is, a
particular outcome will arise rather than a range of outcomes.
DISCUSSION
Is there such a thing as an investment with certain payoffs?
.....
Risk can be measures as a risk premium above the risk-free rate (RFR).
Studies indicate that the long-term average return on an investment portfolio
consisting of the market index (e.g. the FTSE-100) is up to 6 percentage points
higher than that from holding risk-free government securities.7
5
: R. Pike, B. Neal, Corporate Finance and Investment. Decisions & Strategies, Pearson Education Limited,
Harlow 2006, p. 196
6
N. Seitz, M. Ellison, Capital Budgeting and Long Term Financing Decisions, Thomson. South-Western, 2005, p.
345.
7
R. Pike, B. Neal, Corporate Finance and Investment. Decisions & Strategies, Pearson Education Limited,
Harlow 2006, p. 16.
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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
DISCUSSION
Think of sources of risk in investment:
.....
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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
3. Opportunity cost
It measures the value of what society must forgo to use the input to realise the
investment.
In case of investment it’s sometimes referred to as cost of capital.
DISCUSSION
Think of examples of OC in investment:
.....
Speculation:
Gaining profits due to change in price
purchasing (or selling) goods for re-purchase (reselling) based on future price
changes expectations or transfer between markets
Gambling:
Deliberate undertaking new risks, creating of risks
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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
2. Financial investments
FI include all types of securities (financial assets) – for example stock, bonds,
derivatives, equity stakes, etc. – and can be of speculative or nonspeculative
nature.
Financial asset is a claim against some other party for monetary payment.
Financial assets can be defined as intermediary investments because they
have value usually because money was used for some other asset that will
provide cash flows.
We also use term security here:
Security is a legal representation of the right to receive prospective future
benefits under stated conditions.9
The outcome of the analysis is assessing investment effectiveness and the decision
to buy security/accept the project if the investment is worthwhile.
8
S. Serfas, Cognitive Biases in the Capital Investment Context, Gabler Verlag | Springer Fachmedien Wiesbaden
GmbH 2011, p. 13.
9
W. Sharpe, G. Alexander, J. Bailey, Investments, 6th ed., Prentice Hall, Upper Saddle River, New Jersey 1999,
p. 3.
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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
Investment decisions:
a) single investment
b) choosing the best alternative
c) portfolio of investments
Strategy and
Goals
Investment Choice
Financing Sources
Risk and Required
Return
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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
Current assets
Inventories 477,0
Current biological assets 4,1
Trade receivables 313,6
Short-term financial receivables 22,8
Cash at cash equivalents 230,9
Receivables for income taxes 13,0
Other receivables 26,7
Total current assets 1 088,2
http://www.camparigroup.com/en/investor-relations-eng/financial-highlights/balance-
sheet
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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
Non-current liabilities
Bonds 1 086,9
Other non-current financial payables 25,8
Defined benefit plans 9,4
Provision for risks and charges 37,9
Deferred tax liabilities 266,2
Total non-current liabilities 1 426,1
Current liabilities
Payables to banks 36,7
Other financial payables 117,4
Payables to suppliers 223,2
Current payables to tax authorities 4,9
Other current liabilities 127,9
Total current liabilities 509,9
http://www.camparigroup.com/en/investor-relations-eng/financial-highlights/balance-
sheet
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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
10
K. Marcinek, Wprowadzenie do inwestowania, Wydawnictwo Uniwersytetu Ekonomicznego w Katowicach,
Katowice 2014, pp. 60-135.
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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
2. Cost reduction proposals are intended to reduce costs through addition of new
equipment or modification to existing equipment.
11
R. Pike, B. Neal, Corporate Finance and Investment. Decisions & Strategies, Pearson Education Limited,
Harlow 2006, p. 185
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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
Financial markets
Security market or financial market is any mechanism for trading financial assets or
securities. It is a mechanism that brings together buyers and sellers of financial
assets in order to facilitate trading.
Financial markets
1. money market - wholesale funds, usually for less than one year, channelled from
lenders to borrowers.
The market is largely dominated by the major banks and other financial
institutions, but local government and large companies also use it for short-
term lending and borrowing purposes.
2. securities (capital) market deals with long-dated securities such as shares and
loan stock.
The London Stock Exchange is the best-known institution in the capital
market, but there are other important markets, such as the bond market (for
longdated government and corporate borrowing) and the Eurobond market.
3. foreign exchange market (FOREX) is a market for buying and selling one
currency against another. Deals are either on a spot basis (for immediate delivery) or
on a forward basis (for future delivery).
4. derivates market is a market where financial futures and options are exchanged.
Derivatives are securities traded separately from the assets from which they are
derived
Future is a tradable contract to buy or sell a specified amount of an asset at a
specified price at a specified future date
Option is the right but not the obligation to buy or sell a particular asset
Financial market main function is “price discovery”, which means to cause security
prices to reflect currently available information.
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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
Types of securities:
1. Treasury Bill – loaning money on a short term basis to the Government
Treasury, Bills can be also issued by Central National Banks to regulate the
money supply on the market. These securities are short term (up to one year)
and carry very little risk. They are often referred as risk-free assets.
2. Bond – fairly long-term commitment on the part of issuer (the borrower) to the
investor (the lender) involving cash payments each year (the coupon amount)
up to some point of time (the maturity date), when a single final cash payment
(the principal) will also be made.
Bonds can be divided into: government bonds, municipal bonds and corporate
bonds)
12
W. Sharpe, G. Alexander, J. Bailey, Investments, 6th ed., Prentice Hall, Upper Saddle River, New Jersey 1999,
p. 3.
13
R. Pike, B. Neal, Corporate Finance and Investment. Decisions & Strategies, Pearson Education Limited,
Harlow 2006, p. 26.
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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
2) source of capital:
Domestic investors,
Foreign investors:
- Foreign direct investments (FDI) via green field investments or acquisitions
- Foreign portfolio investments (FPI) via financial instruments short term
purchase
- international investors (world bank, regional development banks and other
development financial institutions (DFI)
14
K. Marcinek, Wprowadzenie do inwestowania, Wydawnictwo Uniwersytetu Ekonomicznego w Katowicach,
Katowice 2014, pp. 136-
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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
If the wealth increases through the investment process, the company that invest also
gains value. At the end, the wealth of a shareholder rises.
Financial profit is when inflows exceed outflows (compare profit and loss account,
company earnings calculation).
In economics, the wealth (economic profit) is created if cash inflows exceed cash
outflows by more than what we would have earned if we invested the money
somewhere else during that period (OC).
15
N. Seitz, M. Ellison, Capital Budgeting and Long Term Financing Decisions, Thomson. South-Western, 2005, p.
4.
16 Brigham 296
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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
a) Calculating future value and present value for one period (year):
FV
FV PV 1 r PV
1 r
b) Calculating future value and present value for n periods:
FV
FV PV 1 nr PV
1 nr
where:
FV – the future value of money
PV – the present value of money
r – the interest rate or rate of return per period
n – number of periods (years) of investment
2. Compound interest
FV PV 1 r
FV
PV
n
1 r n
17
W. Sharpe, G. Alexander, J. Bailey, Investments, 6th ed., Prentice Hall, Upper Saddle River, New Jersey 1999,
p. 3.
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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
m n
r FV
FV PV 1 PV mn
m r
1
m
FV PVe nr PV FVe nr
4. Annuity
Annuity Due - An annuity whose payments occur at the beginning of each period.
DISCUSSION
Think of examples of investments where annuities emerge:
.......
Ordinary Annuity:
n
FVA A1 1 r A2 1 r An Aj 1 r
n 1 n2 n j
j 1
A – payment at the end of period j
FVA A
1 r 1
n
for A1 An A
r
FV of Annuity Due
FVAdue A
1 r 1
n
1 r
r
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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
A1 An A PVA A
1 r 1
n
for
r 1 r
n
PV of Annuity Due
PVAdue A
1 r n 1 1 r
r 1 r
n
P
PVperpetuity
r
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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
Price ( %)
B
r E
C D
0
QE A Capital
Quoted interest rate comprise of a real risk-free rate of interest, r*, plus several
premiums:18
18
E. F. Brigham, J. F. Houston, Fundamentals of Financial Management, 11th edition, Thomson South-Western,
Mason, 2007, p. 180-181.
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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
The real risk-free rate is not static—it changes over time depending on economic
conditions, especially:
• objective factor: on the rate of return corporations and other borrowers
expect to earn on productive assets, or long term real growth rate of the
economy,
• And, subjective factor: on people’s time preferences for current versus
future consumption, impatience.
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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
http://www.aspenwealthmanagement.co.uk/Content/uploads/Barclays_Equity_Gilt_st
udy_2011.pdf
1 in 1 ir 1 ii
in ir IP
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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
DISCUSSION:
What changes in each determinant can increase market interest rate and how?
D jt Pjt Pjt 1
TSR R jt
Pjt 1
Djt – dividend per share paid by company j in period t,
Pjt – share price of company j at the end of period t
Pjt-1 – share price of company j at the beginning of period t
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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
FV PV FV
HPY 1
PV PV
1
FV n
r 1
PV
d) Annualized return with continuous compounding
ln FV ln PV
r
n
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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
1.9. Exercises
1. You open an account in a bank. You make a saving deposit for 2 000 PLN. The
interest rate is 10% annually. How much will you get from the deposit if you:
a) Take out the money after one year
b) Take out the money after 2 years and the Bank:
- adds the interest to principal (the money you paid at the beginning)
- do not add the interest to principal
2. You want to go on a trip to India in 2 years. The trip will cost you 7 000 PLN. You
can open a saving deposit in a Bank at interest rate 4%. How much you deposit
today to have enough money for a trip?
3. You want to finance your children (future children) college education in 20 years
from now. Now it cost 25 000 PLN and it is predicted, that the cost will grow at 3%
annually.
a) How much will the cost be after 20 years?
b) How much should you deposit now, if your Bank offers you a rate of interest equal
to 5%?
4. You currently are in position where you can put 100 000 PLN into a retirement
account. If you choose the retirement account, you can earn 8%. How long it will
take you to reach the amount of 500 000 PLN on your account?
5. How much will the investor earn if he invests 1000 PLN for 8 years at a rate of
5%? How much will he earn if the rate increase by 20%?
6. The investor bought shares worth today 4 000 PLN. He will earn 15 PLN of
dividend each year and after 3 years he will sell shares. He predicts that shares
will be worth 5 200 PLN. The investor can also choose alternative investment,
which give him 8% of interest annually. Should he buy the shares? What is his
total shareholder return on this investment?
7. What rate of return should you seek if you want to double your money in 3 years?
8. The investor is buying securities worth today 5000 PLN. He plans to sell them for
6000 after one year. What is rate of return from the investment? Is it efficient (how
much is economic profit)?
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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
10. Suppose you want to invest some money, let’s say 1000 EUR. You can choose
between two options, but you can invest all your money into only one of those
two.
Try to guess which option is better (more profitable) and circle it.
Then, calculate annualized rates of return a) simple (no compounding); b) with yearly
compounding; c) continuous compounding
14. Calculate total interest on loan. The principal of the loan is 10 000 and it will be
repaid in equal yearly instalments over 5 years. Interest rate is 10%.
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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
15. Calculate future value of stream of instalments at the end of year 4. The values of
instalments for consecutive years are: 200, 100, 150, 150. Interest rate is 10%.
Then calculate FV again, however under the assumption that interest rates are
changing as follows: 8%, 9%, 9% i 10%.
16. You have to choose between 2 investment options: the first is offering nominally
14% p.a. with monthly compounding, while the second 14,5% with compounding
twice a year. Which one is better?
17. A principal was invested for 4 years. Nominal annual interest rates are expected
to be as follows: 13%, 12%, 11%, 10,5%. What is future value of the investment?
What are average geometric rate of return (a rate that assumes yearly
compounding) and logarithmic rate of return? What is holding period yield?
21. A company has a loan account of 60 000 at the maximum. The usage of a loan
was as follows:
1.01.– 2 000
15.01. – 16 000
25.01. – 23 000
15.02 – repayment 30 000
04.03. – 20 000
31.03. – repayment of total value of debt
Assuming interest rate of 8% and 360 days/year basis calculate total interest.
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Capital Budgeting & Investment Appraisal Monika Foltyn-Zarychta, Ph.D.
24. Consider a situation that you have been given a choice of 3 investments. The sum
you want to invest is 10 000 EUR. Time period of your investment = 2 years.
The options are:
A saving deposit with annual compounding. Interest rate = 10 %.
A saving deposit compounded weekly with negotiable nominal interest rate.
A saving deposit with continuous compounding and negotiable nominal interest rate.
Due to the fact that you may negotiate your nominal interest rate in 2 and 3, try to
calculate what will be the interest rate making you indifferent between those 3
options. Is this rate may be used in your interest rate negotiations? Explain how?
Real Nominal
rate of rate of Inflation Inflation
return return rate Premium
12,00% 6,00%
1,85% 8,15%
5,15% -3,15%
-20,00% -16,00%
5,00% 7,00% 6,87%
30