Investment Selection Methods: Static vs. Dynamic Approaches

Static Methods of Investment Selection

These methods do not take into account the timing of various cash flows and operate as if all cash flows were received at the same time. The methods are time-based. Key considerations include the Payback Period, total net cash flow, committed currency, and net cash flow per average annual committed unit.

Payback Period

The Payback Period is the time it takes to recover the initial outlay of an investment.

Drawbacks:

• They generally add cash flows regardless of when they are received at different points in time.
• They do not provide the real return on investment.

Advantages:

• It is a simple and intuitive method to calculate.
• It aligns with the company's expectation to recoup the investment minimum quickly.

Dynamic Methods of Investment Selection

These methods address some of the problems found in the static criteria. They include the Net Present Value (NPV) and the Internal Rate of Return (IRR).

Net Present Value (NPV)

The Net Present Value (NPV) is a financial criterion that determines the viability of an investment based on its current cash flows.

Advantages of NPV:

• Takes into account the time at which cash flow is generated.
• Provides a vision of the current benefits.
• Can include phenomena affecting the investment.

Drawbacks of NPV:

• Difficulty in calculating the appropriate discount rate.
• Assumes the reinvestment of annual net cash flows at the discount rate.

Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) determines the discount rate at which the net present value of net cash flows equals the initial outlay. It is based on the internal rate of return of the investment.

Key Investment Terminology

Capitalization

Capitalization is a financial operation in which a quantity of money is invested for a term to earn interest.

Discount

Discount consists of updating amounts from different points in time to their present value.

Taxes

Taxes are compulsory payments from taxpayers to the public sector.

Investment

Investment is the purchase of goods and rights that can be tangible or intangible, and may become part of the assets of a person or entity.

Discounted Cash Flow

Discounted Cash Flow refers to cash flows that are brought to their present value for investment analysis.

Cash Flow

Cash Flow is the difference between receipts and payments.

Investment is a concept relevant both within the economic system and within companies.

• From an economic point of view: Investment is the act of increasing capital.
• From a financial point of view: Investment is the act of placing savings.
• From a legal standpoint: Investment is the purchase of goods and rights that can be tangible or intangible, and may become part of the assets of a person or entity.