In this short report, we will elaborate on the investment and funding decisions made by the financial sphere professionals, and see how different investment appraisal techniques may be utilized in order to assess the feasibility of different scenarios. Also, we will see how such decisions may be implemented and what the consequences of selecting alternative decisions are. As a part of this short research, four specific terms will be explained and defined at the end of the paper.
The essence of investment is to: ‘forego present consumption of resources in order to increase the total amount of resources which can be consumed in the future’ (Duffie 1988). Alternatively an investment can be viewed in terms of: ‘making an outlay of cash now in the expectation of extra cash coming in the future’ (Duffie 1988). The objective of an investment decision is to acquire an asset (real or financial) for less than its value, this way corporate or personal wealth can be increased. Acquiring an asset for at least its value will maintain wealth or value. It would not make good financial sense to acquire an asset for more than its value as wealth would be eroded. From the corporate firm’s point of view the financial manager’s objective should be to invest in projects which add to corporate and shareholder value.
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The problem is that at the outset it is often difficult to determine which assets or projects will be wealth enhancing and which will be wealth reducing. All the more reason we should employ good appraisal techniques and procedures to help us make the right choice. (Matten 2000) For a wealth-maximizing business enterprise, the most common form of investment is in real corporate assets (i.e. land, buildings, plant and machinery, etc.). Such assets are clearly very important since, for most firms, they represent the largest financial investment and are the key earning assets of the firm.
Investment appraisal is not restricted to private sector, profit-seeking, business enterprises. Many public sector, not-for-profit organizations (NPOs) such as National Health Service (NHS) Trusts, are also faced with evaluating decisions to invest in fixed assets (e.g. ambulances, medical equipment, new hospitals or residential homes), usually in the context of having very limited financial resources. (Matten 2000) For such organizations investing in fixed assets also represents a strategic investment decision, as these are the key assets necessary for delivering an effective and efficient service.
As investment decisions normally involve committing large sums of money for the future it is clearly important that they are undertaken with care and that proper procedures and systems are in place for their analysis and selection.
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The general framework of an investment appraisal process involves six distinct but interrelated stages:
1 proposal generation;
2 proposal review and evaluation;
5 follow-up and control;
6 post-implementation audit. (Best 1999)
As with the management process itself, a vital ingredient in the appraisal will be the need for relevant information (financial and non-financial) throughout the process. This appraisal process itself can be costly and time-consuming to carry out. How rigorous or thorough should the process be? Clearly this will be related, among other things, to the size and scale of the investment. For example, for a large company a proposal to purchase a piece of equipment costing $50,000 will require much less evaluation effort than a project costing $50 million. On the other hand, in the context of a small, owner-managed business, a proposal to spend $50,000 on new equipment would be a significant investment. (Duffie 1988)
Depending on individual circumstances, firms are likely to use sophisticated computerized project management packages to facilitate overall management of the project. NPV is considered the more theoretically sound technique and the reason for this is mainly to do with assumptions about the rate at which cash flows generated by an investment project can be reinvested—the reinvestment rate assumption. In other words, what does a firm do with the intermediate cash flows generated by a project? It is unlikely that they are left idle.
The NPV implies that the cash flows which a project generates are reinvested at the firm’s cost of capital or required rate of return, whereas IRR implicitly assumes that the firm can reinvest at the IRR, which is frequently a higher rate than the cost of capital. (Best 1999) The more prudent and indeed realistic assumptions of the NPV are considered preferable. Despite the theoretical superiority of NPV, in practice many managers and firms prefer to use the IRR, essentially because most people are more comfortable in practice with the concepts of rates of return. (Saunders 1999) The NPV method is not really a relative measure, it yields an absolute ? amount, it does not attempt to measure benefits relative to the amount invested. In practice it is easier to compare the IRR with other rates of return provided elsewhere in the market by other investments.
When evaluating independent projects both the NPV and IRR methods will indicate the same accept/reject decision. However, when deciding among mutually exclusive projects, especially projects differing in scale, size and/or cash flow timings, the decision should be guided by the NPV technique. The NPV technique is always considered the preferred criterion. NPV is after all a valuation technique and as the primary goal of financial management is maximizing the value of the firm, then NPV is the only investment appraisal technique that is always consistent with this principal goal. Maximizing shareholder value can be achieved by maximizing the net present value of all the firm’s investment cash flows, subject to applying an appropriate discount rate.
Definition of terms
Investment banker – a person who works for the investment house, which usually means working long hours and conducting IPOs and private placement of different companies, as well as M&A transactions.
Stock market – a place where different securities are traded between professional investors as well as retail audience.
Financial management – management of the company’s financial resources, including cashflows, allocation patterns, and investment decisions.
Risk – a probability of something happening, a factor that should be considered by most of the investment professionals.