Investment Decision Making: Part One

Jim Stockton is senior lecturer in finance at the Warrington School of Management (University of Chester).

Introduction

The term “investment decision making” or, alternatively, “capital budgeting” is used to describe how managers plan significant outlays on new projects or assets-the “big ticket” items. Spending on a large scale has long term implications and businesses usually have many more projects than they can afford to fund so business managers must carefully select and appraise projects from a variety of perspectives. The financial appraisal of projects is termed capital investment appraisal or C.I.A. (and, no, it has nothing to do with the American Secret Service). What follows is a simple (some might argue simplistic) guide to investment decision making.

The basics

Let’s address the basics first. Why do businesses invest in projects or asset purchases-for example-new machinery, new vehicles? Clearly it’s to employ the assets in the business in order to generate sales of products or services. (ignore the example of a car dealer whose business is actually the buying and selling of vehicles). The product or service is then sold, hopefully generating profits which can then be, in part or whole, reinvested in the business to allow expansion and growth. Note that the financial quantum involved will be large, generally speaking, but that will be set within the context of the size of the business. So the purchase of a new van costing £20,000 might be a huge decision for an SME but a “drop in the bucket” for a large plc which may be assessing the competing merits of purchase of a fleet of vehicles of different types possibly costing millions in total.   However, the importance of getting the capital investment decision right is the same for both organisations-it will have long tern consequences in terms of profitability. At the extreme end, it could be a “bet the company” investment decision meaning getting it wrong could be the end of the business.

The business context

It’s important to understand, at the outset, that any capital investment decision has to be appraised within the context of the business. How does the investment fit within the strategic direction defined for the firm?  The long term vision of the company must be articulated with sufficient clarity before investment proposals can be sensibly appraised.  Equally, the markets for the product or services must be fully researched and the customer demand to be satisfied fully understood. Only then does it make sense for projects that “fit” within this business context be developed and examined in greater financial detail.

Types of capital budgeting decisions

What types of business decisions require investment appraisal? Basically any decision involving significant outlay today spent in order to generate increases in revenue or reductions in cost in the future. Typically the following:-

• Expansion decisions-should new facilities e.g. a new factory or machine be acquired to increase capacity and therefore enhance future sales?   

• Replacement decisions-is existing equipment becoming obsolete or in need of modernisation?

• Cost reduction decisions-would it be sensible to invest now in new equipment that will generate savings in the longer term compared with existing machinery? 

• Compliance decisions-has the external regulatory environment changed meaning that current modes of operation are no longer viable? For example, waste products that are a by-product of manufacturing need higher standards of treatment before being released into the atmosphere or watercourse?

All the above are motives for capital investment and therefore financial appraisal.

Information requirements for capital investment appraisal

Let’s assume a business has a number of potential projects and only limited funding available to finance them-a fairly common situation-businesses routinely cannot afford all the projects they may see as commercially attractive. The information required will relate to the future and therefore require estimation (or, if you prefer, informed guesswork!). The information gathering will all be about the future revenues and costs usually expressed as cash inflows and outflows generated as a direct result of the proposed project. Typically the following questions will need answering:-

• What will the new investment cost, for example, the cost of a new machine or a new vehicle? In larger firms the investment may run into many millions.

• What will be the future revenues and costs associated with the investment over the life of the project (difficult one this!). This will require estimates of demand over the life of the projects being appraised and the revenues and costs associated with meeting that demand.

• Will the project have any residual value at the end of its life e.g. scrap value?

Now you can perhaps begin to understand that C.I.A. is all about commercial judgement concerning the future and lacks exact precision especially when thinking about what the economic situation generally may be like and also what the business might be like, in particular, in say five years’ time. Here a word of caution is needed-defer to a friend named G.I.G.O. No it’s not some Italian stunner but an acronym-Garbage In Garbage Out. Put simply, if you feed into your investment appraisal rubbish as your inputs e.g. inaccurate and unresearched assumptions regarding future cash flows that is exactly what you will get out. 

Equally, when estimating future cash flows do not be seduced by spurious accuracy-remember these are broad brush business assumptions regarding the future and you do not have a crystal ball that will deliver complete accuracy so don’t fool yourself into thinking you do!

Sensitivity analysis

Often, when undertaking CIA, one can vary assumptions regarding the cost of the investment and the future cash flows that will result, for example, from different levels of customer demand. In more complicated appraisals, different assumptions regarding inflation or taxation can be introduced. This will help the financial manager assess how “sensitive” the project is to changes in certain factors and therefore help identify where the real business risks lie. But, hold on, let’s not get ahead of ourselves-what are the most commonly used CIA techniques?

Capital Investment Appraisal techniques

There are four commonly used capital investment appraisal techniques:-

1. Payback

2. Accounting rate of Return

3. Net present value

4. Internal rate of return

I will discuss each of these techniques in a subsequent article as they differ substantially from each other and, to make matters worse, often give conflicting answers when applied to the appraisal of, say, two projects competing against each other for limited investment funds. (I didn’t say this would be easy did I? Hey, stick with it, we will get there!).

One final thought, in the shape of a question. If I offered you £10,000 now or £10,000 in a year’s time, which would you choose? The answer may be obvious to you but have a think about why-there are a number of issues involved (at least three) all of which will help in your understanding of capital investment appraisal techniques.

Summary

The above article seeks to expose the basics of investment appraisal in business-nothing more. Think of it as appetiser before the main course. In a subsequent article I will delve deeper into the techniques I have listed above and hopefully deepen your understanding of this important business topic.