The term investment can mean several things. The most general definition of investment according to the Cambridge dictionary is: the act of putting money, effort, time, etc. into something to make a profit or get an advantage, or the money, effort, time, etc. used to do this.

 There are various types of investments: if we consider the time frame, it is possible to distinguish between investments in the short, medium and long term, if instead a classification is made by type, then a distinction is made between real investments and financial investments, where real investments can be either replacement investments or expansion investments. We also know investments in research and development  and other types of investments.

 Of course, the company undertakes investments in order to follow its business strategy and the business objective of the company (read more about it in the section Business Goals ). Depending on how the business objective of the company is usually defined, the company or the entrepreneur must choose those investments that increase the value of the company.

When we talk about investments in companies, we usually mean long-term real investments, ie. investments in fixed assets. These kinds of investment decisions are especially important and burdensome for the company because they usually have an extremely long time frame (several years). For more information on this, see the section " Why is it necessary to make a financial assessment of the investments ?".

It is important to distinguish between expansion and replacement investments. An expansion investment means that a company wants to increase its business, while in the case of replacement investments, it replaces the old investment (a fixed asset…) with a new one. In this case, it is necessary to be careful in determining the cash flows and to consider what the actual effects of the new investment are compared to the old one (i.e., estimate the additional cash flows due to the introduction of the new investment).

Source: Dolenc, P. & Stubelj, I. 2011. Poslovne finance s praktičnimi primeri. Ljubljana.

As we have already seen in this section, when we talk about corporate investments we usually refer to real long-term investments. In general, investment choices are among the most difficult decisions within a company. This depends on various reasons. First, investments usually have a very long time span; in fact, investment projects last for several years, or even decades in the case of building projects. Secondly, such a large period of time represents in itself a fairly high risk, in fact it is very difficult to predict the future effects of the investment and the forecasts can be based solely on expectations. Furthermore, the achievement of the corporate objective will depend on the success of the investments. For this reason, investments must be planned carefully and for this purpose it is absolutely essential to carry out a financial evaluation of the investment project. This means to verify the impact of a given investment project on the adopting structure (the company) in terms of profitability and evaluate the economic sensibility,  starting from the assumption that the investment makes sense if it creates added value for the company. To find out what this means in reality, see the section Financial Analysis of Investments.

Source: Dolenc, P. & Stubelj, I. 2011. Poslovne finance s praktičnimi primeri. Ljubljana.

The financial evaluation of the investments takes place in a similar way to the valuation of the company itself, that is in three phases: 

1. cash flow estimation
2. estimate of the cost of capital
3. evaluation of sensibility

The main specification of the financial analysis of investments is given by the fact that investment decisions are not, or rather should not be based on profit in purely accounting terms, but in terms of cash flow. Cash flow or cash flow represents the net (operating) profit plus depreciation. The calculation of cash flows does not consider the cost of any interest on third-party capital and the income from the investment is primarily reserved for those who have guaranteed the capital, that is, the owners (share capital) or credit institutions (loans long-term). The cost of capital (WACC) is instead considered when discounting future cash flows at present value.

When evaluating an investment project, only the so-called additional cash flows – those immediately related to the investment - should be considered and this is a fundamental aspect, especially with regard to replacement investments. For example, if you replace obsolete equipment that earns € 1 million a year with new equipment that earns € 2 million a year, the real added value given by the investment will be € 1 million a year. If this fundamental aspect is not considered, there is the risk of embarking on bad investments. For more detailed information regarding cash flows, see the section "Which elements should one consider in a financial analysis?".

The cost of the capital needed to finance the investment is given by the weighted average cost of capital (WACC) and in this regard it is good to keep in mind that:

1. The WACC includes the costs of the different types of capital, such as long-term debts, share capital and (if present) the preferred capital.
2. One should take into account the WACC that is valid at the enterprise level (for medium risk investment projects), and not the WACC of a specific investment.
3. The average cost of capital means the cost of capital after taxes: this is why it is important not to underestimate the taxation of interest.
4. The cost of simple share capital must also be considered if the company does not distribute the profits, but retains them or if it is an individual company. Retained profits must also have an adequate return (in relation to comparable investments), otherwise the entrepreneur would need to distribute profits and invest the money in some other comparable investment.

 To find out how to calculate the WACC in practice, see the section "How to calculate the cost of capital and why?"

 Based on the obtained data, we proceed with the calculation of the chosen financial convenience indicator and make a decision. There are various indicators (see the section "What are the financial convenience indicators of the projects and how are they calculated?"), But the most adequate of all is certainly the current net value (VNA).

Source: Dolenc, P. & Stubelj, I. 2011. Poslovne finance s praktičnimi primeri. Ljubljana.