The basics of financial evaluation are not difficult to understand. A person does not have the need to consume only based on the money that he has at that moment. Actually, he sometimes consumes more than he has, and sometimes less.
For it to happen, what is done is to transfer the resources in time. When I bring future resources to the present, I am borrowing. When I transfer my current resources to the future, I am lending.
Depending on the resources that a person owns and their preferences as to when they want to use them, that person can be a lender, a borrower, or both.
Such financial transactions are motivated by the desire to increase their satisfaction by changing the location in time of resources.
This change of resources over time is not free, but there is a cost or a reward depending on whether it is borrowed or lent.
This cost is called the interest rate. The market interest rate is the exchange rate between present and future resources.
Financial Evaluation: Fundamental Concepts
Composition Of The Interest Rate
The interest rate that results from a certain operation is made up of several elements: the “pure” market rate, an additional for inflation, and an additional for risk.
The “pure” market rate is considered the cost of a risk-free investment and is considered the minimum cost or return of any trade. This rate does not exist alone anywhere since any rate that is set in real life has an increase based on inflation expectations that may exist in the period in which the operation is carried out.
In financial markets, the yield on zero-coupon bonds issued by the United States Treasury is considered to be the security that best represents a risk-free rate, therefore that yield is considered the “floor” of the market. That value is usually around 6 or 6.5% per year.
However, if one instead of lending to the United States Treasury, lends to a person or company, there is a probability that they will not pay the interest in the established time, that the funds will be returned after the established terms, Or they don’t give you anything back.
The uncertainty in the returns of a loan (or of any investment that implies a placement of funds in the present, to obtain more funds in the future), is known as risk.
When this risk exists, an investor will request a higher income to compensate for the risks incurred. This higher amount is set as a percentage added to the risk-free interest rate and is called the risk premium.
For example, if an investor invests $100 and can get $106 in an investment without risk, in an investment with the risk he will require $110. Of the $10 pesos he receives for the investment, $4 will be considered the risk premium.
Since a rational investor will not take any risk “for free”, it is considered that the greater the risk of an investment (that is, the greater the uncertainty about its expected returns), the greater the reward that is demanded bearing that risk.
In financial markets, there are risk rating companies such as Moody’s or Standard & Poor’s that rate countries and companies according to their risk.
That rating is what determines the additional risk that will be charged. This means that, for example, when the pure interest rate is 6% per year, the bonds issued by a government of another country are asked for 12% per year interest: that additional 6% per year is based on risk- country, according to the risk estimate made by international consultants.
But the risk that an investment can have is not just one, various risks accumulate.
The risk of the sector, the risk of the company or the individual, and the risk of the activity that is being financed will then be added to the country’s risk.
There is also an additional element, much more complicated, and that is the change that the risk of an additional investment represents in the total risk of an investor’s investment portfolio.
All these risks appear to imply increases in the rate of return that an investor intends to obtain.
The biggest risk of all is when trying to finance a person or small business that has just started, in an activity whose development is unknown because it is relatively new, which is in a new market, and where the company has practically no type of physical goods with which to guarantee the return of the funds.
In these cases, the expected returns can be, for example, interest between 30 and 40% per year on the investment, with the aim of obtaining a return on the initial investment, between 5 and 20 times the value originally reversed.
This means an expected annual return that is between 50% and 80%.
This situation described is the one that is normally found today among start-ups of companies linked to the Internet, and the returns indicated are those required by venture investors for this type of company.