Fundamentals of Investment Appraisal
Learning Objectives;
The interaction between investment decisions and business finance
Classification of Investments and Stages of the Investment Process
Investment Appraisal Techniques
Summary
1. Investment decisions and Business Finance
There are 5 important things to take into account when talking about investment decisions and business finance:
Capital expenditure decisions suppose a substantial expenditure (outlay) but will bring benefits over the long run.
An investment involves the sacrifice of an immediate level of consumption in exchange of the expectation of having an increase in future consumption (i.e., a dividend* now and an enlarged dividend in the future).
To be viable the investment project's benefit has to guarantee its initial capital cost + some extra benefits to compensate the risk.
Decisions on investment projects will have a direct impact on the ability of a company to meet its goals.
Valuation base. For investment decision making we usually use the fact whether the investment project benefits the shareholders as a valuation base.
A necessary pre-condition to undertake an investment is its financing (provide the funds to start and sustain the business).
Main purpose: of the business finance is to assure the financial equilibrium to provide the necessary liquidity for the enterprise.
We have to be concerned whether the funds that finance the investment project are provided by financial markets outside the company, or whether the funds are generated from the returns that the organisation has.
*A dividend is the distribution of a portion of the company's earnings, decided and managed by the company’s board of directors, and paid to a class of its shareholders. Dividends are payments made by publicly-listed companies as a reward to investors for putting their money into the venture. Announcements of dividend payouts are generally accompanied by a proportional increase or decrease in a company's stock price (Investopedia, 2020).
2. Classification of Investments and Stages of the Investment Process
Based on the Nature of the Asset we can differentiate the following investments:
Physical investment (i.e., machinery)
Financial investment (i.e., stocks, or shares in other companies)
Intangible investment (i.e., R&D, employees' education, advertising campaigns, etc.)
Based on the Reason for the Investment we can differentiate two types:
Investment to found or to extend the business
Reinvestment
However, in any type of investment the decision-making process consists of different stages:
Plan.
Identify alternatives and transform them into workable proposals.
Evaluate the alternatives and select the best one (taking into account the organization's goal. To select the investment, appraisal techniques are used. However, the basic question is: whether the benefits of an investment are worth the outlay.
Implement the decision.
Review and select the investment project.
3. Investment Appraisal Techniques
As previously mentioned, to undertake an investment appraisal, several techniques can be used.
The role of the investment appraisal is to ensure that all relevant information, related to the investment alternatives, is gathered to enable decisions to be taken with consideration (taking into account the organization's goal).
We distinguish two different techniques to undertake an investment appraisal:
Non-discounting methods of investment appraisal
Discounting methods of investment appraisal
The most important characteristics of both techniques are the following:
1. Non-discounting methods
The values from the investment are represented through costs and revenues.
The method do NOT focus on the whole life project (its useful economic life expectancy). They work with an AVERAGE VALUE of a representative period.
The time value of money IS NOT considered (which means that whether a payment is made at the beginning or at the end of the economic life of an asset is not taken into account).
2. Discounting methods
The values from the investment are represented through cash inflow and cash outflow.
The point of time at which money is generated is IMPORTANT! as well as, the amount of money to be paid and received from the investment to make the investment decision.
The time at which money is realised is considered. All cash inflows received at different points of time are converted to a common reference point to allow direct comparison.
IMPORTANT!!
Any fix cost, or other profits of the company, will be the same regardless whether the investment is realised or not. They are NOT affected by the investment decision under appraisal.
Relevant data is the marginal, or incremental, cash flow or profit attributable to the start of the new project and NOT to the total cash flow or profit of the company.
4. Summary
Decisions on capital investment are of great importance because they account for a large portion of a firm's financial means.
They are very costly or impossible to reverse and have an impact on the ability of an organisation to meet its goals.
For all kind of investments the stages of the investment process are similar.
The selection of an investment is one of the stages of the capital budgeting process.
This selection process is made possible thanks to the various appraisal techniques (Non-discounting and Discounting methods).
Both methods differ in how to deal with cash flow to be expended or received at different times.
The overall question is: whether the benefits from undertaking an investment are sufficient to guarantee the initial outlay.
All information was gathered from:
Fundamentals of Investment Appraisal by Martina Röhrich - 2nd Edition
You can buy the book in the following link:
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