Investment Term

In this post I would like to make some comments concerning the term INVESTMENT. It is a central notion in investment and project valuation. Many key figures are based on this term. Hence it is important that we really know what it is.

An asset valuation is always done from the fund / capital providers’ or investors’ sight. From that point of view an investment is the amount of cash that the investor has to provide to run the investment project. The cash flow between investor and investment project is the basis of the valuation. Thereby it is not important when the investment cash flow takes place. An investment cash flow does not has to be an initial cash flow in the beginning of the project. An investor can always shift the cash flows by using the capital markets. He can borrow money from a bank and pays it back later with additional interests.

From the investor’s point of view it is not important how the cash is handled in the income statement and balance sheet. The investor is only interested in cash flows concerning him / her. The notion investment does not depend on any classification in income statement and balance sheet. Further it is irrevelant whether the investment cash flow is depreciated / amortized or not.

The investment of a project are all fixed cash flows. That are all cash flows that have no dependency on the market devopment. These are for example cash flows for machines, land, buildings, product development, fixed costs for production, patents, fixed customer payments for various items and further more. It is not important whether these cash flows are incoming or outgoing. In a discounted cash flow analysis the investment cash flows must be discounted with the riskless rate that includes no risk premium. It is incorrect to discount investment cash flows with any discount rate including market risk premiums, for example the WACC. For that reason all figures valuing a project with a single rate (IRR, MIRR, …) are doubtful. They cannot value projects with cash flows having different risk and with it discount rates.

All cash flows that depend on the market development are not investment cash flows. That mainly includes turnover and variable costs. They must be discounted with the appropriate risk adjusted discount rate, because the investor requires a risk premium for taking that non diversifiable risks. Each risky cash flow has its specific own risk and requires an appropriate risk adjusted discount rate.

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