Strategic Investment Decisions - Literature review Example

Strategic Investment Decisions Introduction Investment decisions made by any organisation follow certain patterns and strategies which may result in any number of end results for the investment (Lumby & Jones, 2003). In the corporate environment, the objective to any investment is to ensure that there is maximum utilisation of the resources invested to create as much return for the shareholders as possible (Pike & Neale, 2006). More than investment, the concept of maximising returns can be applied to all areas of corporate behaviour. In the light of this unique investment criterion there are several methods of appraising investments. Discounted Cash Flow Method The Discounted Cash Flow (DCF) method is one of the more common investment appraisal techniques. It has been adopted by and followed at many companies since it takes into account the fundamental fact of financial accounting i.e. the time value of money. Simply put, it means that a dollar today is different in value from a dollar tomorrow (Bazerman, 1998). The DCF method is comprised of three different ways of discounting the cash flows to arrive at an acceptable criterion of investing funds in business. These methods are; Internal Rate of Return (IRR), Net Present Value (NPV) and Discounted Payback Period (Arnold, 2002). It would be feasible to discuss these individually to better understand strategic investment decisions and to allow a comparison between different methods. Internal Rate of Return (IRR) The internal rate of return (IRR) is the rate of return (or the rate of discount) which would make the discounted present value of the expected future returns of an investment exactly equal to the current cost of the investment (Arnold, 2002). The internal rate of return reduces the present value of the investment to the present value of its cost, so that the net yield would be zero. In economic literature (Bazerman, 1998) the internal rate of return is called by the ‘marginal efficiency of capital’ and it is calculated with this formula where Nt represents the expected net profits (that is, Rt – Ct, where R and C are revenues and costs of investment respectively) in the year ‘t’ and the project is expected to last for ‘m’ years, (and ‘i’ denotes the discount rate), the ‘internal rate of return’ on the project is derived from the following relation: m t = 0 t  (1+i)t Through a process of iteration and reiteration it can be seen that If the project has a capital cost of £100 in the year 1 and is expected to yield a profit of £10/year and if the rate of interest were to be, 9 per cent, then the income stream would be: 1 10 10 ----- 10 + ------ 2 + … … + ---- t = £ 110 (approx.) 1.09 (1.09) (1.09) In this example, £110, the present value of the future income stream from the investment is greater than its present cost of £ 100, the interest rate of 9 per cent at which the income stream was discounted is not equal to the internal rate of return required to reduce the value of the income stream to 100. If 11 percent is taken as the discount rate it is seen to be too high a rate as the capitalised present value of the stream of £ 10 will now be equal to approximately£ 91, which is less than the cost of investment. Advantages and Disadvantages of IRR If 10 percent is taken as the trial discount rate, it is seen to be just right, as the present value of the future yield of 10 is exactly 100 which is equal to the present cost, so that the net present value of the investment is zero, and 10 percent is therefore the internal rate of return in this example. This is the central advantage of the system since by using a process of iteration; it is possible to find that exact rate of interest which makes the present value of the net returns equal to zero (Bazerman, 1998). As long as the internal rate of return exceeds the rate of interest at which funds can be borrowed (cost of funds), it is profitable to undertake the investment. As such, it makes the appraisal of any investment a manageable task. The IRR system has several disadvantages as well since criterion has serious disadvantages. It has been shown that using IRR alone as a guide to appraising investment will not lead to accurate investment decisions simply because the very definition of the IRR implies that any intermediate receipts or outlays will be compounded at the same internal rate. In real world situations such an assumption is unrealistic since periodical cash returns from an investment may not be reinvested at the same percentage rate (Rutterford, 1998). Comparison to other Methods Using one single rate to evaluate every investment may simplify matters, but it complicates evaluations if the discount rate changes substantially. Further, in a multi-product firm, if the investment projects are strictly independent of each other, then the IRR criterion can be used, by ranking the projects in terms of their rates of return and proceeding down from the highest internal rate until the available funds are exhausted (Arnold, 2002). The problem in many cases is that investments in such firms are not independent but complementary to each. In such situations, choice between two investment alternatives cannot be made purely on the basis of their IRRs (Lumby & Jones, 2003). Additionally, it may not be possible to determine the IRR uniquely. Such cases occur where the entire expenditure may not be incurred in the first stage; for instance, cases where machinery may have to be replaced from time to time, give rise to negative benefits periodically, which implies that the time profile of net benefits crosses zero more than once giving rise to multiple solutions to the IRR. For this reason, it can be said that the IRR alone is not a satisfactory criterion for appraising investments (Lumby & Jones, 2003). Net Present Value (NPV) An alternative method of assessing the profitability of an investment is to use the net or the discounted present value criterion. The Net Present Value (NPV) is found by discounting (appropriately) all future streams of net income arising from the investment project. Considering that that all future streams of income coming from a singular investment are taken into account, the method is an improvement over the IRR system of evaluations of investment decision (Brookfield, 1995). Comparison to Other Methods Since it is a discounting method, it takes into account the actual values of the funds being invested rather than the focus on rate of return or the time required for the investment to earn itself as in the payback period method (Arnold, 2002). Additionally, since the method creates a result which is positive, negative or a zero value, it can give a better result for comparisons and evaluations if multiple investments need to be evaluated at the same time. Advantages and Disadvantages NPV is calculated by adding to the original investment amount (taken as a negative number), the annual cash flows divided by one plus the appropriate discount rate raised to the number of years during which the cash flow is expected. After calculating the NPV at the decided rate of discount, if the investment shows a positive NPV, it is considered acceptable, if it is negative, it is rejected. If the NPV is equal to zero, the investment decision is in the region of indifference. This calculation is the main advantage of the system because it tells the investors how good or bad an investment is expected to be. As a disadvantage, the choice of the appropriate rate becomes crucial in the NPV since that is the evaluating factor of profitability (Brookfield, 1995). Payback Period The third method of investment appraisal is to calculate the number of years it would take for the recovery of initial investments. All else being equal; the shorter the period of recovery, the greater is the attractiveness of the investment. Dividing the total cost of the project by the (expected) annual inflows gives the number of years required to recover the cost. The formula for that is simple i.e. Cost of the project divided by the annual cash flows gives the payback period (Rutterford, 1998). Comparison to Other Methods This is possibly the simplest method for judging an investment and comparing one investment to another. In opposition to IRR or NPV, the main thrust of this evaluation method is on the time factor of any investment. However, using this method shows that the investor is more concerned with period of investment rather than any other criteria (Lumby & Jones, 2003). With this, it becomes an excellent method for evaluating time based investments where money may have to be blocked for a short/long term. Advantages and Disadvantages Payback Period analysis can be shown to have advantages and disadvantages with this example. If an investment project costs £100 and is expected to give a return of £20 per annum then the payback period is five years. This shows the rationale of payback period analysis that projects with shorter payback periods are more liquid and therefore less risky and allows the investor to have a broader vista of investment avenues for reinvestment of his funds (Rutterford, 1998). These are the advantages since such situations are often created in the real world for. However, the disadvantage shows up clearly when the system shows us that a project which returns £1 million after a six year payback period is to be ranked lower than a project that returns zero after five years. Probably the major criticism of this method is that it ignores TVM and other criteria which make investment evaluations more accurate (Rutterford, 1998). Discounted Payback Period In essence, this system is the modification of the original Payback Period method created by incorporating into a time value of money evaluation (Watson & Head, 2004). Using this method rather than pure Payback Period analysis would be a very useful tool since the example given earlier of a five year investment returning zero would be ranked lower than a six year investment that returns a million in the sixth year of investment. Comparison to Other Methods In DPP, the net cash flows for each year are discounted at the cost of capital to the company. The individual Present Values for each year are added until the sum of the present values is positive and high enough to recoup the cost of investment. The number of years necessary to arrive at this discounted positive amount is the Discounted Payback Period. Since this is a modification of the Payback Period method it can only be directly compared to that method and while comparing the two the DPP methods appears to be the stronger one due to it being more realistic (Arnold, 2002). Advantages and Disadvantages of DPP As an advantage, the Discounted Payback Period method improves the calculation of the original Payback method. But even the improved method ignores any values or benefits that occur after the initial investment is paid back. If one undertakes to discount the annual cash flows to arrive at an appropriate Payback Period, one might as well use a more sophisticated investment appraisal method such as the NPV. The Discounted Payback method gives due allowance to the dynamics of modern technology, where change is as fast as or faster than the changing fashions of the day (Arnold, 2002). Accounting Rate of Return (ARR) The ARR can provide a quick estimate of the project’s net profits and can serve as a basis for comparing several different projects or investments. In fact, that is in itself the most practical use of the method i.e. to make comparisons between investment opportunities (Lumby & Jones, 2003). The validity of the comparisons can be further enforced by using other methods of investment appraisals in conjunction with the Accounting Rate of Return (Watson & Head, 2004). Comparison to Other Methods Considering other methods along with the Accounting Rate of Return (ARR) system, it can be seen that ARR is much simpler and quite straight forwards. The calculations for this method are done by using the quotient of net annual cash flow to initial investment. That is to say, by deducting depreciation values from the annual cash flow and dividing the remaining balance by the initial investment to get the value which is taken to be the Accounting Rate of Return (Arnold, 2002). Advantages and Disadvantages The main advantage of the system is that it takes into consideration both the time involved in the recovery of the investment as in the DPP and Period Payback methods (Watson & Head, 2004). Its deficiency is that it uses profit for evaluating an investment rather than to look at the cash flows. Further, the Accounting Rate of Return (ARR) does not perfectly take into account the time value of money. Company investing in a Long Term Capital Investment Project The company chosen to exemplify investment in long term capital investment project is General Motors (GM). The company is the world’s largest automaker and has been the global industry sales leader for 75 years. Recently, its fortunes have taken a dip owing to fierce competition from automakers from Japan and Korea. To meet on this competition, GM is embarking on a capital investment programme where money has been mobilised from investors in the capital market (Isidore, 2006). Risks of Investment These investors have taken a risk with GM and risk represents the uncertainty that a yield on an investment will be lower than what is expected. The higher the risk of an investment the higher would be the likelihood for large gains or large losses (Kahneman & Tversky, 1979). Among the factors influencing investment risk, a discussion can be made of inflation risk, interest-rate risk, and non-payment of the return on investment. Then there is the market risk, i.e. the ‘market-volatility’ risk, and the marketability risk. Investors may face a random risk related to the possibility that the GM stock may not do well (Isidore, 2006). Taking Risks into Account In the Scenario analysis GM is making an assessment of possible future events by considering alternative possible outcomes (scenarios). The analysis is expected to result in improved decision- making by allowing more complete consideration of outcomes and their implications. For instance, one scenario relates to the sizable labour cost burden in the North American operations. The GM Annual Report states that a large part of their losses come from GM’s huge legacy of cost burden and the problems of adjusting structural costs in line with revenue (GM, 2005). Scenario Analysis Legacy costs include the benefits provided to retired GM employees and employees of other GM business and their dependents. Structural costs are all cost that have to be handled even without production or sales and includes the cost of maintaining unionized employees. This scenario needs significant changes and other scenarios also effect the development of GM’s finances. These include, Product Excellence, which takes into account how GM should improve its product lines. Revitalizing Sales and Marketing Strategy, that discusses how sales can be taken higher than what they are right now (GM, 2005). Wall Street has not expected much profit or any happy news from General Motors for some time but the second quarter results due this month, analysts are looking for a profit statement. It is expected that GM will show a profit of 52 cents a share, compared to a loss of 56 a share a year earlier (Isidore, 2006). Clearly, GM has taken the scenario analysis system to a useful position within their company and has applied the scenarios discussed in a positive manner to become profitable. Decisions Tree Decision theory is a field in management which lets companies come to a decision about taking a risk or otherwise (Bromily & Curley, 1992). The decision tree is a graph of possible consequences for each step taken in a given plan to get to a certain goal (Lumby & Jones, 2003). The tree model itself is a predictive system since it gives observations about an item to get to conclusions about the target value of the decision item (Watson & Head, 2004). Each node of the tree represents several paths which a company can take with their investment and the final point is reached when the objective is fulfilled and there are no more results which can occur (Lumby & Jones, 2003). In the case of GM the decision tree would be based on how the investment would give them returns in the face of the various risks which can result in the investment losing itself to market conditions. Managerial attitude to risk Generally speaking, most investors, including companies, are averse to risk and try to avoid it (Bromily & Curley, 1992). The most transparent behaviour of such investors, particularly if they are company finance officers, is that they demand higher risk premiums as project risk levels increase. They place a relatively low value on small probabilities of a high payoff. As a result, they prefer a lower standard deviation in project returns, holding expected return constant, and, therefore, lower as opposed to higher coefficients of variation (risk-reward ratios) (Kahneman & Tversky, 1979). Hindsight Bias: Hindsight bias is the idea that when a person looks at the past, they think that they know what was going to happen. In business terms, Investors have a tendency to defer to perceived authority figures, including successful investors, strategies, or other market prognosticators (Arnold & Hatzopoulos, 2000). The natural tendency is to view the conclusions of behavioural finance theorists as yet another indication of how poorly everyone else was thinking in the past rather than to see how poorly all investors thought at that time (Blodget, 2004). Word Count: 2,984 (Excluding references) Works Cited Arnold, G. & Hatzopoulos, P. 2000, ‘The theory-practice gap in capital budgeting: evidence from the United Kingdom.’ Journal of Business Finance and Accounting, vol. 27, no. 5, pp. 603-626. Arnold, G. 2002, Corporate Financial Management, Pitman Publishing. Bazerman, M. 1998, Judgment in Managerial Decision Making, J. Wiley & Sons. Blodget, H. 2004, ‘Born Suckers, The greatest Wall Street danger of all: you’, Slate.com, [Online] Available at: http://slate.com/toolbar.aspx?action=print&id=2110977 Bromily, P. & Curley, S. 1992, ‘Individual differences in risk taking.’ in Risk Taking Behaviour Ed. Yates, F., J. Wiley & Sons. pp. 121-122. Brookfield, D. 1995, ‘Risk and capital budgeting: avoiding the pitfalls in using NPV when risk arises’, Management Decision, vol. 33, no. 8, pp. 56-59. GM (General Motors). 2005, ‘Annual Report 2005’, GM.com, [Online] Available at: http://www.gm.com/company/investor_information/docs/fin_data/gm05ar/index.html Isidore, C. 2006, ‘GM’s long winding road to profits’, CNNMoney.com, [Online] Available at: http://money.cnn.com/2006/07/21/news/companies/gm_lookahead/index.htm Kahneman, D. & Tversky, A. 1979, ‘Prospect theory: an analysis of decision under risk’, Econometrica, vol. 47, no. 1 pp. 262-290. Lumby, S. & Jones, C. 1999, Investment Appraisal & Financial Decisions. Thomson Business Press. Pike R. & Neale, B. 2006, Corporate Finance and Investment, Thomson Business Press. Rutterford, J. 1998, Financial Strategy, J. Wiley & Sons. Watson, D. & Head, A. 2004, Corporate Finance: Principles & Practice, Pitman Publishing. Read More