Tools for investment decision making
Company managers continually target tangible and intangible assets, which can increase their business value and, in turn, lead to an increase in shareholders' assets. Capital budgeting focuses on identifying and evaluating possible investment opportunities that would allow managers to make the right investment decisions.
The concept of present value (PV) and net present value (NPV) form the basis for the valuation of tangible assets and investment decisions. In this section, we must use these concepts as managerial decision instruments, which are widely used by companies for the analysis of tangible goods, the recovery of which is spread over several installments. This method establishes, above all, a comparison between the cost of an investment and the present value of the uncertain future cash flows generated by the project.
Tools for investment decision making
There are (at least) 4 steps for analyzing the expected cash flow of a proposed project:
- Assuming that the project is entirely financed by actions (that is to say that the shareholders provide the required capital), this would require the establishment of forecasts relating to the forecast increasing cash flows for the shareholders if the project is accepted.
- It is necessary to establish an appropriate discount rate to reflect the present value and the risks of the project. It will thus be used for the calculation of the present value of the forecast cash flows.
- The NPV of the project must be calculated based on the added value of the current values.
- A decision must be made as to whether to continue the project or abandon it.
Assessment of growing cash flows after tax
Before starting to develop the actual project cash flow model and moving on to the forecast exercise, important technical decisions need to be made. The analyst is called upon to decide what to do to manage inflation. The cash flow model can be established in current or constant currency (that is, net of inflation). These two approaches have advantages and disadvantages in terms of practical aspects, but this essential element must be uniform throughout the model. Next, choose an appropriate forecast period. This can be easy in some cases because the economic life of the assets in question is known. But in other cases, an arbitrary decision would be necessary.
The growing cash flows forecast by companies are made up of four elements:
- The cash flow generated from operations (the cash flow to be generated, through sales, fewer expenses relating to the operation of the project).
- The cash flow generated from capital investments and disposals.
- Cash flow results from changes in working capital (net changes in short-term assets and liabilities).
- These are the payments of additional corporate taxes that result from the implementation of the project.
If the project does not monitor operations after the end of the forecast period, it is then necessary to assess the residual value of the assets. If the management plans a longer duration of the project, it would, therefore, be useful to set a deferral value of the project. The residual value or the carry-over value and their tax implications are then introduced into the valuation model as the last forecast cash-inflow of the project.
Discount rate assessment
The concept of present value includes the concept of the opportunity cost of capital. The appropriate discount rate, or cost of capital, must first compensate the shareholders for the profit they could make on the capital market, by investing in risk-free assets. It must also offer them compensation for the risk they incur by investing in this project rather than in a risk-free financial asset. This is why the cost of capital is determined by the rate of return that the investor intends to make from an alternative investment with a similar risk profile. Fortunately, the wide range of financial assets marketed allows managers to assess the exact rate.
Calculation of net present value
Calculating an NPV of a project is only a technical operation, once the managers have established the cash flow forecasts and the appropriate discount rate. All future cash flows should be discounted to arrive at their present value. In addition, the NPV of the project is carried out by adding these cash flows with the present value of the expenditure required. The projected cash flow of the project in period (t) is represented by (Ct), the present value of the investment required by (Co) (which has a negative sign), and the discount rate by (r).
Note that this traditional NPV model assumes that all future cash flows can be discounted with the same discount rate, which could be very restrictive for certain projects. However, this model can adapt to discount rates that vary from one period to another and to cash flow profiles that show more than one change in sign.
The following decision criteria are relatively straightforward since it is based on the analysis of the project's financial profitability. Assuming that the company operates in a capital market environment where access to capital is not limited, management should accept all projects with positive net present values and optimize its value.
Project analysis methods are widely used. On the one hand, they allow managers to have an in-depth vision and a better understanding of the financial aspects of investment projects. On the other hand, and they highlight the assumptions arising from the cash flow forecasts. They can also give managers more confidence in the analysis of profitability and determine the main risk factors that may compromise the expected result of the investment.
Sensitivity analysis is a very useful way to identify the main variables or guideline values of projects. She directs managerial attention to the most important elements, which are at the origin of the project's growing forecast cash flows.
The magnitude of the change in net present value demonstrates the project's sensitivity to this specific fundamental variable. If, for example, the NPV turns out to be more sensitive to the company's market share and the number of fixed costs than the price of the product, management should. In this case, be interested in the reliability of the market share estimates and fixed cost forecasts. Therefore, he must focus his efforts on setting up the project to improve these factors.
The analysis is slightly more complex. It determines the critical value of each fundamental variable: the NPV of the project equals zero. The above example indicates that as soon as the product's market shares drop or the number of fixed costs. It is called breakeven market share, or fixed breakeven cost exceeds a certain level, the business begins to lose money on the project. The concept of financial breakeven for investment projects is concerned with the recovery of the opportunity cost of the project, as opposed to the accounting analysis of breakeven, which mainly looks at historical costs.
The previous two project analysis methods look at the fundamental factors separately and consider them to be unrelated. Nevertheless, companies often find that many market events will result in a change of several fundamental variables at the same time. If, for example, you are threatened by a new competitor entering the current market, the company's market share and the price could decline. Scenario analysis allows management to examine the effect of possible future event scenarios, which are reflected in the DCF assessment model by uniform changes in the different combinations of the fundamental variables.
Criteria for the alternative decision
Companies of all sizes and in all industries have long used a large number of decision-making criteria to assess their capital investment projects, as a supplement, or worse still, as a substitute for the NPV rule. Let's summarize how these criteria work and compare them to the NPV.
Simple recovery and expected recovery
A simple payback period for a project is defined by the expected number of years that a business requires to recover the initial investment expenses by putting the project in place. The decision criterion is thus presented by the maximum number of years, or by the deadline, from which the proposals on capital investment must be rejected. This implies that the shorter the recovery period, the better the project will be.
However, this rule has two major drawbacks:
- First, it fails to determine the present value of the currency. No investor would accept to invest $ 100 today and receive exactly the same amount the year after and nothing more after that, although this investment is for a payback period of one year.
- Second, the rule excludes the forecast cash flows of the project after the deadline period. It favors projects that have significant recoveries during the first years and maybe nothing after, to long-term projects that gradually increase positive cash flows.
Businesses often use the expected recovery rule to correct the neglect of the present value of the currency. This method includes calculating the recovery period relative to the present value of future cash flows from the project. However, the rule still gives no importance to cash flows after the arbitrary deadline.
Thus, its use should be limited to the comparison of projects which have very similar cash flow profiles. For example, in the real estate sector, many investments should yield a uniformly distributed rent over the long term.
Internal rate of return
The internal rate of return (IRR) for a project is defined by the discount rate, which has an NPV of the project = 0.
For almost all projects, the TIR rule gives the same answer to the question of its acceptance or rejection. However, the use of TIR is inappropriate, for other projects, or needs to be used with great care. These exemptions relate to projects where, instead of an initial investment, the cash flow changes sign more than once during the forecast period or when the company classifies mutually exclusive projects due to technical or capital constraints.
The profitability index of a project is defined by the ratio between the present value of the project's future cash flows and the initial investment (where Co is assumed to be negative).
The rule says that any project with a profitability index greater than one must be accepted, which is analogous to the result of applying the NPV rule, since if IR> I, this means that VA> -Co, and therefore NPV> 0. However, the profitability index is not necessary for reciprocally exclusive project rankings since it is concerned with profitability, not with the size of projects.
Many accounting measures are used in the decision-making process for investment, such as return on investment (ROI) or (Return on Investment) or the average accounting profitability of an investment. The major problem with these measures lies in the fact that they are based on book values , which are very often subject to the arbitrary selection of accounting measures (Example: depreciation programs).
In addition, book values and book income do not reflect the present value of the currency. This is why it is necessary to make several adjustments to achieve significant results.
Extension of the limits of the capital budgeting criteria
As already mentioned, the assumptions fundamental to profitability analysis represent a static approach to decision making and can be very restrictive in some cases. The renewal of future uncertain cash flows by their forecast value and the use of a single discount rate does not take into account any managerial activities during the life of the project.
For example, Managers are taking steps to mitigate losses from adverse market events. These measures maintain or increase profits from favorable changes. Consequence: this can change the risk profile of the project. Also, the profitability analysis is based on making a decision instantly or never. It does not take into account the opportunity that managers can take to delay certain strategic decisions while awaiting the results of future events.
To circumvent these drawbacks, several steps have been taken to develop more sophisticated decision criteria and investment analysis methods. These include genealogical analysis, the use of certainty equivalent to cash flows, and the application of the option price theory in the valuation of tangible goods.
Most investment decisions are based on present value (VA) and net present value (NPV). These are used to make a comparison between the cost of an investment and the present value of future uncertain cash flows that are generated by the project. At least four steps are included:
- Forecasting growing cash flows (which would require some technical decisions such as how to manage inflation).
- The assessment of the appropriate discount rate or cost of capital (determined by the rate of return that the investor could predict from another investment with a similar risk profile).
- The use of this information to calculate the net present value.
- The decision on the possibility of continuing the project.
A better understanding can be provided by the analysis of the sensitivity and the analysis of the neutral point and the scenario analysis. The other investment decision criteria include simple recovery and expected recovery, internal rate of return, and the profitability index.
Author: Vicki Lezama