Firms are motivated to invest by bigger expected profits, expansion of capacity and strategic positioning. All these benefits accrue to the firm in the future and it is thus impossible to quantify them in absolute terms. It’s in this environment of uncertainty that a firm has to make estimates of such benefits and evaluate them to determine how much value each investment will add to the firm. In businesses, investment decisions form one of the critical roles of the management. It is incumbent on the management to choose between the available options and maximizes the future cash flows.
This paper studies the process and environment of investment decision-making. It also studies the details, merits and demerits of traditional techniques used in evaluation of different investment options. It then looks at the shortcomings facing the traditional techniques and the new-age techniques that have come up to overcome these shortcomings.
Investment decision-making procedure
Investment decision-making process is conducted in five stages. The management has to first identify all viable opportunities so that the business does not have to settle for a less profitable project. Then the projections are made to determine the capital outlay, future cash flows and the useful life of every project. The management applies identified forecasting techniques and past data arrive at these projections.
The management then has to select the project (s) to be invested in. In this stage, it has to carry out both financial and qualitative appraisals of all the projects. Financial appraisal is a critical process conducted using quantitative techniques identified. These techniques rank the projects in order of viability. Future cash flows are discounted to make comparison possible. The capital outlay for the projects must also be within the available funds. The risk involved with each project must also be considered. Projects selected by quantitative techniques should then be evaluated qualitatively as the business does not operate in a vacuum.
The projects selected must meet set societal, environmental, political, legal and labour standards. If ignored, these factors may place obstacles to the operation of the project. After the project is selected, it is then implemented according to specifications. The final phase involves post implementation project review, which involves comparison between actual data and the projected figures. (Ryan, Bob, 1995: 133, Lucey, Terence, 2003: 410).
Challenges facing managers
The capital budgeting environment is very challenging for managers. They have to maximize shareholders wealth by putting the company resources into viable projects. They are faced with limited capital and can only take up some but not all of the viable projects. Taking up a non-viable project would mean that the business lost an excellent opportunity to invest in more profitable ventures. These projects may also have huge capital that becomes sunk cost once the project is implemented giving no room for retraction. Failure to some investments may also be very costly to the firm in the long run. Managers are faced by a number of investment decision-making problems.
Firstly, the manager has to rely on quantitative techniques in forecasting and evaluating future cash flows for each project. These techniques are subject to numerous assumptions that may severely limit their ability to produce accurate results. These techniques also rely heavily on past data that may not be a true reflection of what will happen in the future. Changes may affect the ability to implement the project fully or affect its results. The macroeconomic environment in which the business entity operates in may undergo significant changes and managers will have this in mind while capital budgeting.
Interest rates may go up raising the cost of capital significantly. Projects may also be disrupted greatly if the government changes its tax policy. These changes may make some viable projects to be infeasible while previously infeasible ones become viable. Thirdly, new projects may trigger off labour rows. This is especially where the investment results in job cuts. Workers unions may oppose the investment leading to much delay and extra costs.
If an investment spurs profitability without necessarily leading to job losses may lead to demands for higher wages. Employees feel that they need to be rewarded for higher productivity. Labour disruptions are therefore a cause for concern when selecting investment (Ryan, Bob, 1995:146). Managers have traditionally applied a number of techniques to evaluate and rank different projects quantitatively.
Accounting rate of return
Also known as Return on Capital Employed (ROCE). It a ratio of profit after depreciation with capital invested in the project. It is in the form of a percentage and the manager selects the projects from the one with the highest ARR.
ARR = average annual projects generated by the project
Average investment over project life.
While it is quick and simplistic, it is unpopular as it does not work with cash flows and fails to consider time value of money. It also tends to favour the project with a smaller cash outlay since investment amount is the denominator. (Lucey, Terence, 2003: 410)
It ranks projects in order of recovery of initial capital. It focuses on speed of recouping the investment.
PP = Cost of project
Annual cash flows
Its weaknesses are that it ignores future cash flows that occur after the pay back period and a project that has average cash flows over a longer period may be overlooked by a project with initially high cashflows, which rapidly declines in a short time. It also fails take into account time value of money. In spite of these demerits, mangers may still apply it. This is because of pressure from shareholders for quick results. Banks also prefer to lend to short and medium-term borrowers to long-term projects. However it is used to supplement other appraisal techniques. (Ryan, Bob, 1995: 145)
Discounted cash flow method
It ranks projects after their future cash flows have been converted into present values. This method caters for the opportunity cost of capital invested. To discount, managers use a rate of return that represent the risk associated with the cash flows.
The PVs of the cash flows are then added up for each project and ranking is done from the one with the highest DCF. It is advantageous in that it takes into account the time value of money. It also takes into account the risk premium investors require due to the risk associated with the uncertainty about the future. However, it is affected by assumptions made in arriving at the growth rate and rate of return.
Net present value
It is a widely used project appraisal method that measures PV of net cash flow. It measures the value each project adds to a firm. It involves discounting all cash inflows and outflows back to their present values and adding them up.
To arrive at the appropriate discount rate, managers mainly apply cost of capital for the firm. But it may be adjusted upward where the risk involved is higher. Managers may also apply a firm’s reinvestment rate, which takes into account the opportunity cost of investments and is thus more accurate. NPV falls as the discount rate rises. NPV also is higher if inflows are larger and occur sooner after investment. In selecting the projects, all project with an NPV less than zero are rejected as they reduce value to the firm.
Where NPV is equal to zero, the project neither adds nor reduces value to the firm and the firm may choose accept or reject the project on a qualitative basis such as corporate social responsibility or strategic positioning. Such a project’s future net cash flows will be positive if they are not discounted. However, not all projects with a positive NPV are undertaken in the face of limited capital and opportunity cost of other projects. The manager undertakes investments from the ones with the highest NPVs until the capital outlay is exhausted. NPV is also a useful in deciding whether to borrow funds for an investment or not. A manager can borrow funds only for a project with a positive NPV.
NPV is advantageous in that it helps a firm achieve its primary goal of expanding shareholders’ wealth through projects that add value to the firm. It also takes in to account time value of money. It also relies on cash flows rather than profits. However the process of arriving at discount rate is quite complicated and subject to many assumptions. (Lucy, Terence, 2003: 416)
Internal rate of return
IRR is defined as the discount rate that results in NPV equal to zero. It is calculated through equating NPV to zero and solving for the discount rate.
In appraising projects, managers compare the IRR with the company’s cost of capital. Projects with IRR larger than cost of capital are acceptable while those with a lesser IRR are rejected. It is advantageous because it takes in to account time value of money. It is also very responsive be variations of interest rates. It is quite complicated in computation and may sometimes conflict with NPV. It cannot also be used to rank mutually exclusive projects. (Cannarito, Steve, 2003)
NPV and IRR are superior over other traditional methods of project appraisal. There is a strong relationship between the two as they have almost similar formulas and use time adjusted data. However NPV measures return as an absolute term while IRR is a percentage. This makes NPV more preferable as it gives the range of each investment. While these two measures usually give the same verdict, there are instances when they differ depending on type of project, cash flows and scale of investment.
For independent projects both criteria give a same verdict if the cash flows are normal. For dependent projects, NPV and IRR give contradictory verdicts where the two projects are both acceptable. When choosing between two projects of different scale, the two techniques may differ. However in such instances NPV should be used since it ensures that the scale of investment is optimised. Also companies set targets in absolute rather then relative terms. (Lucy, Terence, 2003: 416)
Traditional methods of investment appraisal are however deficient in a number of ways. Firstly, these techniques are not holistic in their approach. They only consider the impact of projects only in the investment. It may trigger a reduction in labour in another department, which is left out in decision-making. Secondly, they only consider financial data and disregard other salient features of project that enhances the positioning of a firm.
A firm may make a strategic investment to enhance its position in an industry such as improving flow of information both within and externally. Other projects especially in systems and software development are conservatively assumed to have zero value yet they greatly contribute to the firm’s operations. Benefits drawn from such investments are not readily accommodated in the traditional appraisal techniques. They are also regarded as being quite sophisticated and only understandable by people in a certain field hence not regarded.
Shortcomings of the traditional appraisal techniques
Thirdly, the traditional appraisal techniques over emphasize on the short run. Projects that have a very positive impact on the firm in the long run are shunned in favour of projects that allow capital invested to be quickly recouped. Some investments that enhance the position of the firm such as a flexible manufacturing process requires a length process of development and implementation and is shunned regardless of benefits it grants the firm. Fourthly, there is an overriding assumption that the investment and investment condition will endure over time.
In this regard, the cost of not making a certain investment over time may be quite significant to even threaten the existence of the firm or expose it so greater competition. Fifthly, overemphasis on traditional appraisal techniques pushes investment managers to submit overly optimistic figures in a bid to influence top management to take up their projects ahead of other submissions.
Finally the various traditional appraisal techniques treat inflation inconsistently. In the payback period method it dealt with internally while it is considered to be part of the rates applied in ARR. In DCF and NPV inflation is also assumingly dealt with clearly. However no provisions are made for price rises against future cash flows (Alder, R, 2002)
Faced by the above weakness, the traditional appraisal techniques are bound to sometimes make erroneous judgment by ranking a less viable project a head of a more viable one. The management also looses focus of the long-term standing of the firm to concentrate only on the very short-term. These demerits have led to the introduction of advanced appraisals techniques. These techniques are developed through two methodologies. One is to reinforce the traditional appraisal techniques to try to overcome their accompanying deficiencies.
It involves accommodating non-financial benefits accruing to project into the appraising process. The various weaknesses are reduced or completely removed. In this approach, there is a firm believe that the traditional appraisal techniques are not in themselves deficient but it is the user who is deficient or rigid. Proponents then introduce modifications that correct those short coming. The second methodology is founded on introduction of new-age appraisal methods that are quite different from the traditional techniques.
Strategic cost management
SCM are significantly different from traditional techniques by incorporating other strategic features into the decision making process. It involves management of costs to ensure the firm gains on edge in the industry both in the short and long term. Costs are managed while laying the firm’s strategies and when evaluating the strategies after implementation to ensure that the firm has an enduring competitive edge. The first step is to come up with strategies, which are then inculcated in to all employees of the organization.
Cost accounting information is used in the development and selection of viable strategies. These strategies are also communicated to employees in form of accounting information. The strategies are improved on and adopted. Accounting information is also useful in the implementation process to provide guidance on the best methodologies. Finally, the firm lays down strategies assessment and control in the post implementation period. Financial information here is used to evaluate whether managers have achieved the set goals.
Managers using SCM have to carry out a value chain analysis, which is surgery of the entire business operations to maximize value addition and minimize cost to the firm. They also have to conduct a competitive advantage analysis that involves reinforcing the company’s position in the market through cost management. Finally, the managers conduct a cost driver analysis that involves identifying the cost drivers and ensuring the cost structure of the firm is optimal (Shank, J and V. Govindarajan, 1993: 1-19)
Multi attribute decision model
This criterion is based on utility derived on making an investment. It incorporates evaluation of non-monetary data on the results of investing in a particular project alongside the financial measures such as payback period and NPV. The non-financial criterion is set by the managers inclusive of issues that are highly valued by the firm such as a better image or raising efficiency in company operations and flow of information.
The measures are then weighted in accordance to how much the firm values them. Ratings are then attached to the investing alternative in accordance to their ability to meet the non-financial criteria. To arrive at the total score of each investment, the product of weights and rating of each investment for each non-financial measure are added up. (Alder, R 2002)
Value analysis and the analytical hierarchy method
These techniques are closely related to the MADM but use different techniques to collect information. The Delphi method is used to collect information in the value analysis method. A group of experts in the field of investment is drawn and each member forwards the pros of adopting the particular investment anonymously. The members then vet each advanced benefit repeatedly and come up with a final list. This list is then used to compute the weights rating and the likelihood of each factor.
The analytical hierarchy method, on the other hand, involves a group of selected managers interviewed to match up two by two factors. The resulting relationship is then adopted for mathematical analysis to come up with the rating weights and likelihood. Manager responses can be evaluated for any inconsistencies. (Alder, R 2002)
Research and development (RD) method
This method evaluates projects with more emphasis on advancement and application of research and development role of the projects. The projects are assumed to be the results of research work done by the organization. The procedure applied in this technique is in two distinct phases. Firstly, the benefits that accrue to each tentative project are examined to determine whether further appraisal should be done or whether to reject the project out rightly. In the second phase, analysis is done on the costs to ensure that they do not overtake the benefits.
Where they do, the project is rejected. Then a pilot program is implemented for evaluation. The advantages are that real data can be obtained from the pilot project while top managers encounter the pilot project and develop acceptance for the whole project (Alder, R 2002)
Used to evaluate project whose outcomes are quite uncertain. The managers evaluate the magnitude of success and failure of the project rather than the likelihood of either outcome. They estimate the magnitudes of either outcomes making the investment and that of not doing so. Then optimistic and pessimistic percentages are attached to the corresponding success and failed outcomes. Then the percentages are then multiplied with the corresponding absolute estimates arrived at earlier. The firm takes up the option with highest positive value and the lowest negative value. (Alder, R 2002)
Investment decisions are quite critical to a firm’s survival in the long run. It is therefore important to employ accurate appraisal methods on investment options available. Traditional techniques have numerous shortcomings mostly due to their narrow perspective and overemphasis on financial data. New age techniques seek to resolve these shortcomings by mainly incorporating non-financial data into the decision-making process. However these new age methods cannot be relied on solely. Traditional methods are best employed in financial data evaluation while the new-age techniques evaluate non-financial data. The two types can be used jointly to provide a holistic appraisal approach.
Ryan, Bob, 1995. Strategies Accounting For Management: Investment Decision. Thomson learning. Pg 133- 146
Lucey, Terence, 2003. Management Accounting: Investment Appraisal 1. Thomson learning, 5th edition. Pp 410- 419
Cannarito, Steve, 2003. Smack Down in San Antonio: “infernal” IRR vs. “nasty” NPV. CCIM institute. Retrieved on 01.17.08 from ccim.com/conference/san_antonio/SAHandout1.pdf
Alder, R 2002. Strategic Decision-Making. Confernz ltd. Retrieved on 01.17.08 from http://www.conferenz.co.nz/strategic-investment-decision-making.html
Shank, J. and V. Govindarajan, 1993. Introduction To Strategic Cost Management. Freeload Press, Chapter 1. Pp1-19