Investment and Sources of Financing
Ximena owns a bakery in Guadalajara and wants to buy a new oven for $\$15{,}000$. Buying it is investing: spending today to earn more tomorrow. But first she has to come up with that $\$15{,}000$, and that is financing. They are two different decisions, and both have to be made well: what to spend on and where to get the money.
Investing and Financing
Money and Savings
All of this works because money exists. Money serves three functions:
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Medium of exchange: you buy and sell with it without bartering (you pay for the torta with pesos, not with tortillas).
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Unit of account: it is used to measure and compare prices, costs, and profits in a single unit.
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Store of value: it lets you keep purchasing power to use later.
Savings are the part of income that is not spent on consumption. That saved money is the raw material of financing: a saver deposits it in a bank or lends it to the government (for example, by buying Cetes), and the financial system channels it toward those who want to invest. That is why whoever lends is paid an interest rate: it is the price of using other people's money.
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…
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.
Own and Outside Sources, Internal and External
Internal is always own. Outside is always external. External can be own (more capital from the owners) or outside (debt). That is why external sources can be divided into own and outside, and the outside ones are the group that has to be repaid.
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…
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…
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.
Outside Financing: Term and Instruments
To get an asset (for example, a delivery van) there are three paths:
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A loan to buy it. The van is yours from the start. Advantage: full ownership. Drawback: it usually requires a down payment, increases debt, and maintenance is up to you.
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Financial leasing. You pay rent, and at the end you can keep the asset by paying a residual value. Advantage: you don't pay everything at once and you can buy it at the end. Drawback: in total it costs more than paying cash, and the contract is hard to cancel.
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Pure leasing or long-term renting. You pay a fee to use it, normally with maintenance and insurance included. Advantage: almost no initial outlay and predictable expenses. Drawback: it will never be yours, and at the end nothing is left.
Insurance: Protecting What Is Financed
An insurance policy is a contract in which you pay a premium to an insurer and, in return, it covers a risk if it occurs (a crash, an illness, a fire). It does not prevent the problem, but it keeps one big blow from wrecking your finances. Everyday examples:
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Auto insurance: covers damage and theft. Banks and leasing companies almost always require it while the vehicle is still financed.
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Major medical insurance: covers hospital stays and surgeries that the IMSS or the public health service cannot handle in time, or that you want to take care of at a private hospital.
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IMSS social security: the employer and the worker contribute to get medical care, disability leave, and a pension.
Example: if Ximena's van is worth $\$180{,}000$ and the annual insurance premium is $\$6{,}000$, she pays $\$6{,}000$ a year so as not to risk $\$180{,}000$ in a crash. It is a small, known cost against a large, uncertain risk.
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…
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.
Payback: How Long Until I Recover What I Invested?
It is easy to calculate, and that is why it is widely used. But it has three important limits:
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It ignores what happens after the outlay is recovered. A project may take a little longer and yield a great deal afterward.
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It does not consider the time value of money: $\$1{,}000$ today is worth more than $\$1{,}000$ three years from now.
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It does not measure the size of the gain: two projects can have the same payback and be very different in how much they earn in total.
An investment requires an initial outlay of $\$400\,000$ and generates annual cash flows of $\$100\,000$ for six years. a) Calculate its payback period. b) Explain what…
An investment requires an initial outlay of $\$400\,000$ and generates annual cash flows of $\$100\,000$ 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 $\$360\,000$ and returns $\$120\,000$ per year, and B costs $\$480\,000$ and returns $\$160\,000$ per year. a)…
A company is choosing between two investments: A costs $\$360\,000$ and returns $\$120\,000$ per year, and B costs $\$480\,000$ and returns $\$160\,000$ 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.
NPV and IRR: Money Is Worth Different Amounts Over Time
Why discount? A peso today can be invested and grow; one that arrives in two years is worth less today. That is why flows from different years cannot simply be added: first they are brought to the same moment, the present.
A management team evaluates a project that requires an initial outlay of $\$10,000$ and will generate two consecutive annual cash flows of $\$6,000$ each. The sales…
A management team evaluates a project that requires an initial outlay of $\$10,000$ and will generate two consecutive annual cash flows of $\$6,000$ each. The sales director states: "The project will generate $\$12,000$, so we will make a certain net profit of $\$2,000$ 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.
The Cost of Financing and the Risk of Borrowing
Financial Leverage
Return on equity (ROE) measures how much the owner earns for each peso of their own:
$$ROE = \frac{\text{Net income}}{\text{Own funds}} = \frac{EBIT - \text{interest}}{\text{Own funds}}$$(without taxes, for simplicity). EBIT is earnings before interest and taxes (in Spanish UAFIR; some texts show it as BAII, the same concept). Return on assets (ROA) is $\frac{EBIT}{\text{Assets}}$.
If the asset yields more than the debt costs, borrowing raises ROE: this is positive leverage. If it yields less, it sinks it.
Debt multiplies both gains and losses, and interest is paid even when there are no profits. The more debt, the greater the financial risk (the risk of being unable to pay, or insolvency).
Distribute or Retain Profits
Profits can be distributed as dividends or retained as reserves (self-financing). If everything is distributed, the next project is financed almost entirely with debt: debt and interest go up. Retaining avoids paying interest and improves solvency, although the owners collect less today. That debt is "cheap" today does not guarantee it will stay that way if interest rates rise: many loans have a variable rate.
The partners of a family SME disagree on the allocation of the $\$80,000$ net profit earned this year. The majority partner proposes distributing $100\ \%…
The partners of a family SME disagree on the allocation of the $\$80,000$ net profit earned this year. The majority partner proposes distributing $100\ \%$ in dividends and financing the opening of a second location (cost: $\$150,000$) 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 $\$500,000$ and a projected Earnings Before Interest and Taxes (EBIT) of $\$60,000$. ALFA finances its…
Two competing companies, ALFA and BETA, have total assets of $\$500,000$ and a projected Earnings Before Interest and Taxes (EBIT) of $\$60,000$. 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 $\$24,000$). Based on these results, interpret the concept of financial risk.
Back to the beginning: to buy her $\$15{,}000$ oven, Ximena must check that the future flows, discounted, exceed what it costs (positive NPV, or an IRR greater than the cost of financing; with a payback of 3 years). Then she chooses the source that will not choke her liquidity: retained profits (her own savings), a term loan, or a lease, making sure the payments are covered by the cash the oven itself generates.