Exercises: Investment and sources of finance

Explain the difference between investment and finance, and classify these operations as one or the other: buying a new oven, taking out a bank loan, retaining part of the profits to expand the premises, and leasing a van with a purchase option.

Sources of finance can be internal or external, equity or debt (own or external funds). Classify these four: a share capital increase among partners, self-financing through retained earnings, a five-year bank loan, and machinery leasing.

The figure shows the map of a company's sources of finance. Identify the missing group of sources, marked with "?", state how these sources are also called (equity or debt), and give two examples.

An investment consists of paying an initial outlay today in exchange for receiving cash flows in the coming years. An ice cream parlour is studying a project that requires an initial $15.000\ \text{€}$ and would generate $4.000\ \text{€}$ in the first year, $5.000\ \text{€}$ in the second and $6.000\ \text{€}$ in the third. Identify the initial outlay and the cash flows, and explain in your own words what the company must compare to know whether the investment is worthwhile.

Explain in your own words what the Net Present Value (NPV) of an investment measures and what it means if it comes out positive, negative or zero. Also reason why future flows are discounted instead of being added directly to the outlay.

Explain what the Internal Rate of Return (IRR) of an investment is and what rule is followed when comparing it with the discount rate or with the cost of financing. Apply it: is a project with an IRR of $8\ \%$ worthwhile if the bank charges $5\ \%$ for the loan? And if it charges $10\ \%$?

External financing sources can be short-term (repaid in less than a year) or long-term. Classify these: the trade credit of a supplier that collects in 60 days, an eight-year bank loan, a credit facility to cover cash flow gaps, a ten-year bond issue and bill discounting.

A sports shop takes out a loan of $10.000\ \text{€}$ at a fixed interest rate of $4\ \%$ a year. a) Calculate the interest it will pay after one year. b) Explain the difference between the capital lent, the interest and the instalment repaid to the bank.

An investment requires an initial outlay of $20.000\ \text{€}$ and generates annual cash flows of $5.000\ \text{€}$ for six years. a) Calculate its payback period. b) Explain what this criterion measures and what its main limitation is.

A company is choosing between two investments: A costs $18.000\ \text{€}$ and returns $6.000\ \text{€}$ per year, and B costs $24.000\ \text{€}$ and returns $8.000\ \text{€}$ per year. a) Calculate the payback period for each. b) Reason why the payback period criterion, used on its own, can lead to a bad decision even if the periods turn out to be equal.

A bakery needs a delivery van and is considering three options: a bank loan to buy it, leasing, or renting. Explain what each option consists of and give an advantage and a disadvantage of each for an SME with limited cash flow.

A printing house invests $30.000\ \text{€}$ in a machine that will generate cash flows of $12.000\ \text{€}$ in the first year, $10.000\ \text{€}$ in the second and $8.000\ \text{€}$ in the third. a) Calculate the payback period, reasoning year by year how much remains to be recovered. b) Comment on one advantage and one limitation of this criterion.

A project requires an initial outlay of $16.000\ \text{€}$ and will generate flows of $9.000\ \text{€}$ in the first year and $10.000\ \text{€}$ in the second, with a discount rate of $6\ \%$. a) Calculate the NPV with the formula $VAN = -A + \frac{F_1}{(1 + k)} + \frac{F_2}{(1 + k)^2}$. b) Reason, from the sign of the result, whether the project should be carried out.

An investment of $10.000\ \text{€}$ will return a single flow of $11.500\ \text{€}$ in one year. a) Set up the IRR by equating the NPV to zero and solve for its value. b) Decide whether it is worth carrying out if the company finances itself at a cost of $6\ \%$.

A workshop needs to finance a machine costing $24.000\ \text{€}$. The bank offers a three-year loan at $5\ \%$ a year simple interest, and a leasing company asks for instalments of $750\ \text{€}$ a month for three years. a) Calculate the total cost of each option. b) Reason what other differences, besides cost, the workshop should consider (ownership of the asset, maintenance, flexibility).

An app start-up with no track record and no assets to offer as collateral needs $100.000\ \text{€}$, and an established factory needs $300.000\ \text{€}$ to renew machinery. Propose the most suitable financing source for each (venture capital or business angels versus a bank loan) and justify the choice according to risk, the guarantees required and the surrender of ownership involved.

The partners of a family SME disagree on the allocation of the $80.000\ \text{€}$ net profit earned this year. The majority partner proposes distributing $100\ \%$ in dividends and financing the opening of a second location (cost: $150.000\ \text{€}$) entirely with a bank loan at $6\ \%$, arguing that "debt is cheap and profits belong in the owners' pockets." The Chief Financial Officer warns that the current debt-to-equity ratio is already $1,8$ (liabilities over equity) and that the sector faces interest rate hikes. a) Rebut the majority partner's arguments by assessing the impact of their proposal on the company's financial risk and financial autonomy. b) Design a justified alternative proposal that combines self-financing and external funding, detailing the necessary conditions for the investment to create value for the partners.

Two competing companies, ALFA and BETA, have total assets of $500.000\ \text{€}$ and a projected Earnings Before Interest and Taxes (EBIT) of $60.000\ \text{€}$. ALFA finances its assets with $80\ \%$ debt at an annual interest rate of $5\ \%$ and $20\ \%$ equity; BETA uses $20\ \%$ debt at $5\ \%$ and $80\ \%$ equity (ignore taxes). a) Calculate the return on equity (ROE) of both companies in the projected scenario and justify in which one financial leverage acts more strongly. b) Predict what will happen to the return on equity and the solvency of each company if a crisis reduces EBIT by $60\ \%$ (down to $24.000\ \text{€}$). Based on these results, interpret the concept of financial risk.

A management team evaluates a project that requires an initial outlay of $10.000\ \text{€}$ and will generate two consecutive annual cash flows of $6.000\ \text{€}$ each. The sales director states: "The project will generate $12.000\ \text{€}$, so we will make a certain net profit of $2.000\ \text{€}$ regardless of the economic situation." a) Formally prove the director's flawed reasoning by calculating the Net Present Value (NPV) with a cost of capital of $5\ \%$ and justifying why it is not valid to directly add heterogeneous cash flows over time. b) Determine the discount rate above which the investment would cease to be profitable (calculate its IRR) and interpret what would happen if the central bank raises interest rates above that threshold.

A company must choose between two mutually exclusive investment projects with an initial outlay of $20.000\ \text{€}$ each: Project X generates $10.000\ \text{€}$ per year for three years; Project Y generates no cash receipts in the first year, generates $18.000\ \text{€}$ in the second, and $16.000\ \text{€}$ in the third. a) Calculate the payback period and the Net Present Value (NPV) of both projects with a discount rate of $5\ \%$. b) Analyze why both criteria offer contradictory recommendations, pointing out the two fundamental theoretical limitations of the payback method that cause this conflict. c) If the company faces severe short-term liquidity strains but its shareholders prioritize maximizing the long-term value of the firm, which project would you recommend in each case? Justify your decision.

An investment department analyzes a project requiring an initial outlay of $20.000\ \text{€}$ that will generate two net cash inflows: $11.000\ \text{€}$ at the end of the first year and $12.100\ \text{€}$ at the end of the second year. a) Analytically calculate the Internal Rate of Return (IRR) of the project and interpret its economic meaning as a hurdle rate. b) If the company's cost of capital is $6\ \%$, justify, without needing to calculate the numerical value of the NPV, what sign it will necessarily have and what decision should be made. c) What would happen to the project's feasibility if financial tensions raise the cost of capital to $12\ \%$? Reason through the behavior of the NPV as a function of the discount rate.

A publishing house is considering launching a collection with an initial outlay of $50.000\ \text{€}$ and net cash flows of $20.000\ \text{€}$, $25.000\ \text{€}$, and $30.000\ \text{€}$ over three consecutive years. The opportunity cost of capital is $7\ \%$. a) Evaluate the economic feasibility of the project by calculating its Net Present Value (NPV). b) The financial team is debating between two potential risks: inflation driving up financing costs to a discount rate of $11\ \%$, or competition reducing all cash flows by $10\ \%$ while keeping the rate at $7\ \%$. Predict and quantify which of the two scenarios would damage the project's value more. c) Theoretically justify the relationship between the time horizon of the cash flows and the sensitivity of the NPV to changes in interest rates.

An industrial company has a financial structure composed of $60\ \%$ equity, whose shareholders require a return of $9\ \%$, and $40\ \%$ bank debt at a cost of $4\ \%$. a) Determine the company's Weighted Average Cost of Capital (WACC) and explain why shareholders demand a higher return than the cost of bank debt. b) The company is evaluating two independent investment projects: Project A (IRR of $8\ \%$) and Project B (IRR of $6\ \%$). Justify which one(s) should be undertaken. c) The CEO proposes financing Project B by increasing the share of bank debt to $80\ \%$ to lower the weighted average cost and make it profitable. Critically refute this proposal by arguing the effect of indebtedness on the risk premium required by shareholders.

A furniture factory has purchased an industrial warehouse in cash for $200.000\ \text{€}$ by relying exclusively on 11-month credit lines renewable annually. After the transaction, its balance sheet shows: Non-Current Assets $= 350.000\ \text{€}$, Current Assets $= 80.000\ \text{€}$, Current Liabilities $= 240.000\ \text{€}$ (includes the credit line), Non-Current Liabilities $= 40.000\ \text{€}$, and Equity $= 150.000\ \text{€}$. a) Calculate the Working Capital and explain, based on the principle of maturity matching in financing, the financial imbalance incurred by the factory. b) Predict the sequence of financial events to which the company will be exposed if the bank decides not to renew the credit line. c) Design a financial restructuring proposal that restores stability, quantifying the minimum amount of debt that must be transferred to the long term or to equity to achieve a positive Working Capital of $30.000\ \text{€}$.