Investment appraisal

This page looks at some basic principles of investment appraisal and then directs you to specific techniques and models

Objectives

With any decision it is vital to understand what is trying to be achieved in the first place as this will influence the method to be used.

Maximising shareholder wealth

The most common objective in investment appraisal is to maximise shareholder value. This is because most decisions are made by companies where the directors have a duty to act in the interests of their shareholders.

Research has found that  to develop decision making metrics that maximise shareholder value, the following factors need to be incorporated:

1  Cash is preferable to profit

Cash flows have a higher correlation with shareholder wealth than profits.

2 Exceeding the cost of capital

 The return, however measured, must be sufficient to cover not just the cost of debt (for example by exceeding interest payments), but also the cost of equity. Peter Drucker commented, in a Harvard Business Review article: ‘Until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxes as if it had a genuine profit. The enterprise still returns less to the economy than it devours in resources… until then it does not create wealth; it destroys it.’

3 Managing both long and short-term perspectives

Investors are increasingly looking at long-term value. When valuing a company’s shares, the stock market places a value on the company’s future potential, not just its current profit levels.

Company announcements – about capital expenditure, research and development, or new investments – are often treated as positive rather than negative factors by the market, even though these announcements may have a detrimental effect on short-term profits. New biotechnology companies, for example, clearly have a value despite the fact that many currently have no products.

Taken together, these would suggest the use of discounted cash flow techniques.

Improving profitability

Despite a poor correlation with shareholder value, many businesses focus on increasing profit. This is due mainly to familiarity and simplicity. Popular profit based measures include the following:

• Return on capital employed / Accounting rate of return

Other objectives

Many other objectives can be incorporated into decision making. Some are more complex that others. For example:

• Liquidity concerns can be incorporated by setting a target payback period
• Trying to simultaneously maximise return while minimising risk can get very complex!
• Some objectives are very difficult to quantify (e.g. impact on quality of life of local residents when appraising a decision to build a new shopping centre)

Relevant cash flows

From a theoretical standpoint decisions should only consider factors that are directly affected by the decision:

If we consider:

A: the cash position if we accept a project

B: the cash position if we don't

then the key figure is the difference between A and B.

Decisions should thus be based on future net incremental cash flows , also known as "relevant cash flows" or "opportunity cash flows".

There are three elements here:

• Cash flows. To evaluate a decision, actual cash flows should be considered. Noncash items such as depreciation and inter divisional charges should be ignored.
• Future costs and revenues. This means that past costs and revenues are only useful insofar as they provide a guide to the future. Costs already spent, known as sunk costs, are irrelevant for decision making.
• Incremental costs and revenues. Only those costs and revenues that alter as a result of a decision are relevant. Where factors are common to all the alternatives being considered they can be ignored; only the differences are relevant. 

Where this type of analysis can get more subtle is when the cash flow for not accepting a project (B in our example above) is not zero. Rather we consider the next best alternative (if we don't do the project, then what else would we do instead) and consider cash flows avoided or foregone.

• If doing the project means we have avoided a cost, then we have an "opportunity saving",
• if we have revenue foregone, then an "opportunity cost".

Time value of money

Most methods of long term investment appraisal take into account the "time value of money". This recognises the fact that money paid out or received now is worth more to us than the expectation of the same amount at some future date. this is due to the following:

• Investment opportunities - money received now could be invested and hence grow to a larger sum in the future
• Cost of finance - if we have a loan, then money received sooner could be used to repay it and save interest.(Alternatively, payments made now might increase a loan or overdraft resulting in higher interest payments)
• Inflation - inflation erodes the purchasing power of money. $100 now will buy more than $100 in five years' time.
• Risk - future cash flows are less certain

The implications of this can be very significant, particular for long projects.

The time value of money is reflected in techniques such as NPV, IRR, MIRR, discounted payback and duration.

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