Investment Decision

The investment decision-making process

A typical model for investment decision making has a number of distinct stages.
a)

Origination of proposals

b)

Project screening

c)

Analysis and acceptance

d)

Monitoring and review

Relevant cash flows

Relevant costs of investment appraisal include opportunity costs, working

capital costs and wider costs such as infrastructure and human development
costs.

Relevant costs are future, incremental, differential

Non-relevant costs include past costs and committed costs.

Here are some examples of non-relevant costs:

a)

Centrally-allocated overheads that are not a consequence of undertaking the

project

b)

Management costs and marketing research expenditure already incurred

c)

Depreciation

Opportunity Costs

These are the costs incurred or revenues lost from diverting existing resources
from their best use.

Example

If a salesman, who is paid an annual salary of $30,000, is diverted to work on

a new project and as a result existing sales of $50,000 are lost, the
opportunity cost to the new project will be the $50,000 of lost sales.

The salesman's salary of $30,000 is not an opportunity cost since it will be

incurred however the salesman's time is spent.

Technique # 1:Payback Period

Payback is the amount of time it takes for cash inflows = cash outflows.

Payback is often used as a 'first screening method' in investment appraisal. By

this, we mean that when a capital investment project is being considered,
the first question to ask is: 'How long will it take to pay back its cost?

The organisation might have a target payback, and so it would reject a

capital project unless its payback period were less than a certain number of
years.

Payback Example

Project P pays back in year 3 (about one quarter of the way through year 3).
Project Q pays back half way through year 2. Using payback alone to judge
capital investments, project Q would be preferred.
However the returns from project P over its life are much higher than the
returns from project Q. Project P will earn total profits before depreciation of
$140,000 on an investment of $60,000. Project Q will earn total profits before
depreciation of only $25,000 on an investment of $60,000.

Investment Appraisal using DCF

techniques

Discounted cash flow, or DCF for short, is an investment appraisal technique

which takes into account both the timings of cash flows and also total
profitability over a project's life.

The timing of cash flows is taken into account by discounting them. $1

earned today will be worth more than $1 earned after two years. This is
partly due to the effect of inflation, and partly due to the greater certainty in
having $1 in hand today compared to the promise of $1 in a years time.

In addition, cash we have in hand today can be spent or invested elsewhere:

for example, put into a savings account to earn annual interest.

Compounding and Discounting

Discounting starts with the future value, and converts a future value to a present
value. Discounting tells us how much an investment will be worth in todays terms. This
method can be used to compare two investments with different durations.

Question
Spender expects the cash inflow from an investment to be $40,000 after 2
years and another $30,000 after 3 years. Its target rate of return is 12%.
Calculate the present value of these future returns, and explain what this
present value signifies.

Technique # 2: Net Present Value (NPV)

Net present value or NPV is the value obtained by discounting all cash
outflows and inflows of a capital investment project by a chosen target rate
of return or cost of capital.

Decision rule: Opt the project which has positive NPV

Annuity Factor

Technique # 3:Internal Rate of Return

(IRR)

The internal rate of return (IRR) of an investment is the cost of capital at

which its NPV would be exactly $0.

The IRR method of investment appraisal is an alternative to the NPV method

for investment appraisal. This method is to accept investment projects whose
IRR exceeds a target rate of return. The IRR is calculated approximately using
a technique called interpolation.

IRR - Method

IRR Question

A company is trying to decide whether to buy a machine for $80,000 which

will save costs of $20,000 per annum for 5 years and which will have a resale
value of $10,000 at the end of year 5.

If it is the company's policy to undertake projects only if they are expected to

yield a DCF return of 10% or more, ascertain whether this project should be
undertaken.

NPV and IRR compared

There are advantages and disadvantages to each appraisal method

The main advantage of the IRR method is that the information it provides is
more easily understood by managers, especially non-financial managers