Some rules of thumb you should never forget when investing

RULES TO FOLLOW WHEN APPLYING THE NET PRESENT VALUE RULE FOR INVESTMENTS

1. CONSIDER ONLY CASH FLOWS: when an accountant has to register the expenses in the acquisition of an asset it will not register the full amount of the expense but the part of the expense related for the year. Example: if the firm buys a $20,000 machinery that will be in use for 5 years, each year the accountant will deduct $4,000 as current expenses. This is done in order not to show on the financial statement a huge expense that could make investors think that the company is performing poorly. When you are computing NPV you should compute it with the whole expense of the asset and not with the current expense you deduct each year. In order to go from the accounting income to the real cashflow, you have to add back the depreciation that does not represent a real cashout of all the years and subtract the real one: the whole cost of the investment. The net working capital or simply working capital is defined as the difference between the company’s assets and liabilities in the short term. Examples of assets in the short terms are inventories (both of raw materials and finished products) and examples of short term liabilities are account payable or taxes that have not be paid yet. You have to be careful never to forget about the working capital of a firm or about the fact that you need to be careful that many factors, like the increase on prices, may affect it. Working capital can be thought as the value of the assets that will bring profits. Net working capital is recovered entirely when the project for what it is used finishes.

2. BE CAREFUL ON WHAT YOU CONSIDER AS COSTS. Always remember to include taxes because they represent a real cash out. You should also be aware of the difference between average and incremental payoffs. Average payoffs are associated with investments with good past performance but that is not guaranteed that they will continue to do so in the future. Incremental payoffs are associated with those investments that may not have had a spectacular performance in the past but that can exploit opportunities for future growth.

3. NEVER FORGET ABOUT INCIDENTAL EFFECTS. Never consider projects alone: imagine that Apple wants to launch a brand new iPhone, this move will surely generate a lot of earnings in the future but it is also true that it will damage the sales of old iPhones that are the result of past investments. Another example might be the owner of a bridge and all the shops above it. If the owner of the bridge invests money to make the bridge more beautiful he will receive more money because more and more people will want use it and they could also be interested in buying from the shops on it. You should always include opportunity costs because, even if they are not real costs they influence the decision about whether an investment is worth or not. You should never consider sunk costs because, by definition, you can not do anything to recover them. Consider all the costs such as light, rent, electricity that are directly related to the investment. If you will need heat for your new plant you will have to include it as a cost. If you already pay for the heat in your office, carrying on another project will not influence the fact that you will still need to pay those costs and therefore you should not consider them. Think of whether you will be able to sell the asset after you stopped using it (like a machinery for example) and the taxes you will have to pay on that transaction.

4. NEVER FORGET ABOUT INFLATION. Usually cashflows and discount rates are considered in nominal term. In order to pass from a nominal to a real representation of cashflow and interest rates you have to multiply the each cashflow by (1+i)^t where i is the inflation rate and t the time period considered and calculate the real discount rates as:

1. CONSIDER INVESTING AND FINANCING DECISIONS AS SEPARATE. Even if you receive the money for a project by entering into debt, you should not consider its additional costs (such as the interests you have to pay) when computing present value.