Strategic Investment Decision Appraisal Techniques - Essay Example

Investment Proposal

The term shareholders define individuals who legally own stock shares in an organization. In running businesses, the primary focus is usually on ways of maximizing the shareholder’s value through maximizing the profits. The shareholders usually play an important role in the management of an organization by providing the necessary capital for the successful running of a company. Therefore, it is essential for the management of the company to develop ways that help ensure the wealth of the shareholders is maximized through maximization of the dividends to shareholders through time (Windsor 2010, p.441). By maximizing the shareholder’s value, the value of the company is also optimized.

Shareholders are usually apart of the stakeholders whose decisions or actions have a remarkable effect on the achievement of the firm’s objectives. Therefore, in consideration of the ways of maximizing the shareholder’s wealth, it is necessary to focus on the effect that these decisions have on these groups of stakeholders. This paper, therefore, aims at preparing an investment proposal for the product line with an objective of maximizing the wealth of the shareholders of the company listed in the textbook publishing industry. In the creation of the necessary advice that is key in the maximization of the shareholder’s wealth, it is necessary to note that this paper intends to suggest a discounted cash flow technique as well as the traditional cash flow techniques.

Investment appraisal implies the necessary techniques for determining whether the new project is worth funding (Akalu and Turner 2001, p.7). In the consideration of the techniques of investment appraisal, it is important to consider the merits and demerits. While selecting the applicable method for appraising the new product, it is also necessary to consider some of the factors that tend to vary with every organization (Adler 2000, p.15). Some of these factors include the objectives of the business, the status of the economy, SWOT analysis, and analysis of the stakeholders. In the design for the investment proposal for the new product line, the discounted cash flow method to consider is the Net Present Value (NPV). Investment appraisal is essential because it gives a realistic sense of the potential risks and rewards necessary for predicting the risks and rewards that are achievable (Savvides 1994, p.3).

Investment appraisal plays a significant role in the prediction of the outcomes. Through investment appraisal, it is possible to determine the potential results of the project and hence be able to predict the result. Therefore, through investment appraisal, an individual can choose the most satisfactory result for investment. Investment appraisal also helps in determination of the project or product that can offer the quickest return or the highest annual rate of performance. Through finance, appraisal individuals can make an appropriate decision on the financing option that offers the best performance. Through investment appraisal, it is also possible to make an investment decision based on the risks available. Investment appraisal helps in the making of the decisions based on the risks such as loss of lawsuits and other uncertainties that have a significant impact on the potential rewards of the project.

The proposal for the new product line considers the factors of the investment appraisal, which are crucial in determining the most appropriate technique to consider for maximizing the shareholders wealth. On consideration of the existent factors of the organization, which is internationally listed within the textbook publishing industry, the applicable discounted cash flow technique is the NPV. The choice of NPV is based on the merit of the technique of putting into consideration the time value of money (TVM) (Efinance Management n.d, p.1). The method relies on the principle that money is usually worth more than it is in the future. Since this proposal for the new product line spreads over a period of six years, it is necessary to choose a technique that considers the time value of money. The NPV method ensures that the outflows of the new product or project are treated as negative while the inflows are treated as positive. The resultant NPV is thus the sum of the value of the present values (PV) of the flow of capital that arise because of the introduction of the new product to the market.

The decision on the investment of the new product is based on the viability of the new product which is determined by the nature of the NPV, whether it is positive or negative. Positive NPV implies the new product is financially viable and hence assures of increase in wealth of the shareholders. Negative NPV, on the other hand, implies that the new product is not economically viable thus; investment on the project is likely to report a decrease in wealth of the shareholders. Zero NPV, however, implies that the new product breaks even thus reports no return on the shareholder’s investment. In consideration of these aspects of NPV that are essential in decision-making, it is possible to determine whether to invest in the new product or not. Therefore, it is prudent to undertake the decision that reports a positive NPV as there are high chances of increasing the shareholder’s wealth through the implementation of this technique in comparison to the other decisions.

The consideration of the time value of money is determined by the factors such as risks and the opportunity costs. The money in the future is usually uncertain hence the risk. The opportunity cost helps in the prediction of the outcome of the investment through assuming that the invested wealth of the shareholders will be able to earn interests in the future.

In consideration for NPV, it is necessary to determine a discounting technique that is more applicable to the new product to be introduced to the market. Different discounting methods exist such as discounting annuities and discounting perpetuities. Discounting annuities imply a discounting technique implemented on constant annual cash flow for a given number of years (Shu, Zeithammer & Payne 2016, p.251). Discounting perpetuity entails a discounting procedure that is applicable to the annual cash flow, which occurs forever. Since the new product to be introduced is expected to involve constant annual cash flow over a period of six years, it is prudent to implement the annuity discounting rather than discounting perpetuity.

Through discounting, it is possible to adjust the contemporary value of the investment by the shareholders to a value in the future. While discounting, it is important to consider the rate of interest as the choice of the appropriate rate that is essential in determining the life of the project, which in this case is a new product to be introduced by the organization. The amount of money invested by the shareholder is thus multiplied by a discounting factor that helps in the conversion to its NPV depending on the duration of the project in question. Shareholders are likely to place higher values on the recent returns rather than in future ones. Therefore, it is important to focus on a technique that discounts the future values into their PVs at specified time value. The preference of the shareholders thus plays substantial part in establishment of investment appraisal technique, which will put these factors into consideration. Through discounted cash flow (DCF) method, it is possible to evaluate and select an investment project more objectively (Lawrence 2009, p.1). The economic value in the case of the firm is six years, which implies the economic life of the project in question.

While implementing NPV, the cash flows of the new product investment are to be discounted based on the appropriate rate of return, which should be equivalent to the capital’s cost (Bilych 2013, p.78). The decision to invest in the new product depends on the profitability of the project over the duration of the investment. The profitability of the project is determined by higher cash inflows as compared to the cash outflows resulting from the introduction of the new product in the market. Higher capital inflows imply the wealth of the shareholders can be maximized hence the shareholders money should be invested in the project.

The choice of the NPV technique depends heavily on some of the advantages that it has over other technologies. One of the benefits associated with this technique is the fact it indicates the value added to the total investment of the shareholder through taking up the proposed investment at a selected discounting rate. The fact that NPV ponders both TVM and the cash flows within the economic life of the introduced product that is introduced is also an added advantage. The consistency of the objective of NPV with the maximization of the wealth of the shareholders of the firm makes it more suitable for the consideration for the appraisal of the investment of the shareholders (Efinance Management n.d, p.1).

However, there exist some demerits of using the NPV in the appraisal of the shareholder’s investments. One major fault is the difficulty in utilization and comprehension of the technique. The problem arises from the requirement of actual cash flows, an accurate lifetime of the project and specific discount rate. There appears difficulty in determining these factors accurately as they are mostly based on assumptions obtained from the study of the history of similar projects that have been implemented successfully. The selection of the discount rate that is appropriate for the determination of the NPV is also difficult as there is no defined method for its accurate determination.

NPV technique as well assumes that there is possibility of reinvesting the cash flows at the same rate of interest, which is not practicable. In the determination of the NPV of the product over the six years, there are some significant assumptions. These assumptions are that the cash flows usually occur at the start or end of the year while the initial investment occurs at the initial period of investment. The other assumption that is made of the cash flows while determining the NPV is that other cash flows commence a year after the investment (Efinance Management n.d, p.1). However, the merits of this technique outweigh its demerits hence the suitability of its implementation over other discounting methods.

The traditional technique applicable in the determination of the ways of improving the wealth of the shareholders is the average rate of return method. Average rate of return (ARR) technique implies the means of evaluating the investments of the shareholders on the new project. ARR method helps in the determination of the profit resulting from the investment of the shareholders. The ARR is usually determined by calculating the lifetime benefit, which implies the difference between the total inflows within the investment period of the product and the outflow (Magni 2014, p.177). The resulting average profit is then divided by the total number of years of the project, which in this case is six years. The return is derived as a percentage. However, these techniques pose significant challenges as in addition to ignoring the time value of money, it is also harder to implement and time-consuming as well. However, the resulting percentage returns are essential in showing the profitability of the project over the investment period.

In the implementation of the NPV as a way of improving the wealth of the investors is applicable because of the timeliness of the technique. The procedure accounts for the time value of the investment of shareholders while at the same time considering some of the challenges that might arise during the investment period through the discounting implemented. Therefore, the assumptions during the calculation of the various costs are justified as they consider almost all the factors that are likely to affect the invested capital. The implementation of the ARR as well suggests a method of calculating the rate of return, which can be easily implemented. Even though several significant factors are assumed in the implementation of the ARR, the process remains valid in the prediction of the rate on return of the shareholder’s investments.

For successful implementation of NPV and ARR, it is important to take into account the stakeholder’s role in the achievement of the organization’s objectives. The stakeholders include the suppliers, creditors, directors, employees, the government, and its agencies. The stakeholders play an important role in ensuring that the new product to be introduced is as per the client’s specifications. Therefore, it is necessary for the organization to guarantee that they are innovative and good rapport is maintained with the stakeholders.

A good rapport between the interested parties and the firm is essential to guarantee that the quality of the product delivered is maintained throughout the duration of investment of the shareholders. For instance, right relationship between the suppliers of the raw materials for the new product and the firm will help ensure timely production and supply of the product. The timely delivery of the services by the stakeholders to the organization is vital in ensuring the success of the company. Therefore, the investment appraisal techniques applied are likely to uphold because of the stable conditions that favor successful implementation of the developed strategies of ensuring the wealth of the shareholders is maximized.

In the application of the NPV on the investment of the new product as a way of maximizing the wealth of the shareholders, it is necessary to consider the time value of the money. Consideration of the time value of money is required to ensure that there are profits on the capital invested by the shareholders thus increasing their wealth. Therefore, in the process of implementing NPV on the new project, the firm should as well be able to compensate the shareholders proportionate to the duration of their investment on the product. Ensuring that the compensation is reasonable over the period of investment on the project will thus help the organization in achieving the objective of maximizing the investor’s wealth sufficiently.

Additionally, NPV accounts for the time value of money, which is essential in the determination of the premium on the investment that is considered against the risk of the capital sum not being repaid. Therefore, the return must be proportional to the risk undertaken by the investors in investing their money in the new product of the firm. Consequently, the firm will ensure that the activities that relate to the new product are maximized to compensate the shareholders in accordance with the outcome predicted by the NVP and ARR.

NVP also considers the time value of money while predicting the outcome of the investment on the new product based on inflation. NVP puts into account the extent to which the capital invested by the shareholders loses its value or purchasing power over time. Through the consideration of inflation, the organization can make the decision on the best way possible that the shareholders can be compensated for the declining power of the money they invest in the new product over the six-year period. Therefore, NPV plays a significant role in putting into consideration most of the factors that relate to the time value of money which are likely to affect the return on investment of the investor’s money.

Even though NPV and ARR are the best solutions that apply to the organization to increase the wealth of the shareholders, these techniques pose significant challenges hence the criticism. For instance, ARR tends to implement the straight line method of gathering quantitative information regarding investment on a product. The method thus pays more attention to the positive measure hence leading to the lack of sophistication. ARR also is inconsiderate of money’s time value hence the results obtained indicates that the returns taken in the later years are less worthy than the current yields (Magni 2014, p.177). The technique also does not consider the cash flows, which is essential for the maintenance of business. The NPV, on the other hand, is difficult to explain to managers. The difficulty in the explanation arises from the need for knowledge in accounting or cost of capital for successful comprehension.

Furthermore, the requirement of the NPV of precise calculation of costs poses the challenge in the implementation of the projects that are intended for long durations. Implementation of the method is as well difficult due to its complexity thus limiting its application. The technique is also based on an arbitrary choice of interest rate. No defined means of determining the interest rate exist which best serves the interest of the shareholders, which is to increase their wealth. The NPV as well do not show profitability calculated as a percentage rate resulting in difficulty in the choice of investment. NPV technique usually has insignificant control for the duration of the investment.

In the decision-making process on the appraisal, a procedure to be implemented is based on the logical analysis of the existing conditions of the new product. The study is mainly focused on the economic evaluation of the status of the firm, the new product and the duration of the intended investment. On completion of the economic evaluation, it is possible to choose whether to accept or reject the proposal to the investment and the money of the shareholders in the project. On analyzing, the results obtained from the NPV technique can either be zero, positive or negative results. The positive result, in this case, implies that the new product should be introduced according to the plan, as the product is likely to earn profits for the firm. More profits made by the company implies the wealth of the shareholders is maximized. On the other hand, a negative result of the NPV indicates that the project is not viable hence the implementation of the idea to introduce new product will result in losses. Losses incurred by the firm impacts negatively on the wealth of the shareholders hence unsuitable. Consequently, the launch of the new product will have to be rejected. Zero result on the NPV implies that the new product if introduced, would lead to break-even whereby there are no profits or losses. Break-even is unsuitable because the introduction of the new product will have no effect on the money invested by the shareholders in the firm.

Reference List

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Akalu, M.M. and Turner, J.R., 2001. Investment Appraisal Process (No. ERS-2001-78-ORG). ERIM Report Series Research in Management.

Bilych, AV 2013, 'Theoretical and practical aspects of business valuation based on DCF-method (discounted cash flow)', Economy Of AIC, 8, pp. 78-84, Business Source Complete, EBSCOhost, viewed 25 June 2016. (p.78)

Efinance Management, n.d, Why Net Present Value is the Best Measure for Investment Appraisal?, Web, 25 June 2016, https://www.efinancemanagement.com/investment-decisions/why-net-present-value-is-the-best-measure-for-investment-appraisal

Lawrence, EC 2009, 'Biases in Mid-Year and End-of-Year Conventions in Discounted Cash Flow Models for Corporate Valuations', Journal Of Legal Economics, 16, 1, pp. 1-15, Business Source Complete, EBSCOhost, viewed 25 June 2016 (p.1).

Magni, CA 2014, 'Mathematical Analysis of Average Rates of Return and Investment Decisions: The Missing Link', Engineering Economist, 59, 3, pp. 175-206, Business Source Complete, EBSCOhost, viewed 25 June 2016. (p.177)

Savvides, S., 1994. Risk analysis in investment appraisal. Project Appraisal,9(1), pp.3-18.

Shu, S, Zeithammer, R, & Payne, J 2016, 'Consumer Preferences for Annuity Attributes: Beyond Net Present Value', Journal Of Marketing Research (JMR), 53, 2, pp. 240-262, Business Source Complete, EBSCOhost, viewed 25 June 2016.

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