Login with Facebook

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.

Decision Criteria 

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

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

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.

Neutral analysis

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.

Scenario analysis

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.

Profitability Index 

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.

Accounting measures

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.

In short

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 returninvestment decision making, and the profitability index.

Author: Vicki Lezama


Comments

Need a custom
essay?

We will write it for you.
Order now

Free Essay Examples

Free essays:

All you need to know about Neuroendocrinology
All you need to know about Big data management
All you need to know about digital special effects
All you need to know Technical Writing?
Basics the Game Theory in Cryptoeconomics
Business innovation ideas for making money
Biosensors for cancer diagnosis
Business Analysis: Pricing strategies and Demand Curve
Consciousness: characteristics and peculiarities
Conservation Economics
Cybersecurity in business: challenges, risks, and practices
Corporate Behavior
Dance as an art form and entertainment
Discrimination Economics
Determinants of Wages
Deontology Vs. Utilitarianism
Ethics: an essay on the understanding of evil
Emotions: what are they? Theories explained
Economy and Air Pollution
Economic Externalities and How to Deal with Them
Factors Affecting Purchasing Behavior
Financial Statement Analysis
Factors Influencing Interest and Exchange Rates
Fiscal and Monetary Policies in Response to 2008/2009
Government's Intervention in The Labor Market
Guide on the Pathways of the nervous system
Game theory in microeconomics
Globalization: definition, causes, social impact and risks
How women can manage sexual harassment
How to conduct economic research?
How to define the Enterprise Value
How cancer is developed - Cancer biology
Imperfect Information and Asymmetric Information
Imperfect Information in Insurance
Introduction to Labor Markets
Investment in Human Capital
Journalism: What is News?
Journalism: Broadcast media and Television Presenters
Journalism: Sources of News
Journalism and Law
Key Determinants of National Income
Key Factors That Affect Pricing Decisions
Kinetic models in biology and Related fields
Know about the different forms of traditional African dances
Latest technology trends
Latest dance trends
Microeconomic Analysis to the Demand for Labor
Modern journalism
Neuromuscular disorders
National Economies, Fluctuation, and Responses to Fluctuations
Neurotransmitters: what they are and different types
Nanomedicines to target tumors
Organizational motivation and its effects
Overcoming Hiring Challenges for Nonprofit Organization
Parkinson's disease
Perspectives on Television: Analysis
Russian School of Mathematics
Research and Development
Risk Sharing in Insurance and Asset Markets
Risk and the value of information
Structure of the nervous system
Structure of a Corporation
Schizoaffective disorder: how to live better with it
Segregation in the US.
The Role of Internal Audit in Corporate Risk Management
The Use of Law on Economics and Vice Versa
The political theory of Thomas Hobbes
The Game Theory in Social Media
Unions
Unemployment
Utilitarianism Vs. Kantianism
Understanding Auctions and Auction Theory: Part 2
Various theoretical perspectives of sociology
Virtual reality, what it is and how it works
What is Transcranial magnetic stimulation (TMS)?
What are the different genres of films?
4 Facts about Origin of Mathematics!
5 techniques to create an animation
10 emerging technologies according to World Economic Forum
10 strategies to maximize corporate profits
3d Model Of Building
6 Medical Technologies that revolutionized the healthcare in 2020
All you need to know about the ACA Code of ethics
Architecture and Democracy: An Introduction
Architecture and Democracy: Democratic Values
Architecture and Democracy: Democratic Procedures
All You Need to Know About a Synthesis Essay
An essential guide to understanding Film Theory
Application of Artificial Intelligence in Cyber Security
Applications of electrical engineering
Augmented reality: what it is, how it works, examples
Advantages And Disadvantages Of Social Networking
All you need to know about Cryptography
Applications of astrophysical science
All you need to know about architecture engineering
Applications of geological engineering
Artificial intelligence and medicine: an increasingly close relationship
An insight into Computational Biology
ACA code of conduct
A Rose for Emily
Applications of Mathematics in daily life
Architecture mistakes to avoid
All you need to know about Toxicology
All you need to know about Holistic Medicine
All you need to know about linguistics
An introduction to Linguistics and its subfields
All you need to know about Anxiety disorder
All you need to know about Drones
A Brief Insight into Political Science
Assumptions related to feminism
All you need to know about Byzantine emperors
All you need to know about labour economics
An insight into xenobots -the first-ever robots
An ultimate guide about Biomaterials
A Comprehensive Introduction to the Mona Lisa
Analysis methods of Transport through biological membranes
An ultimate guide about biochemical reactions
Analysis of brain signals
Artificial Gene Synthesis
Application to synthetic biology of CAD methods
All you need to know about metabolic pathways
Applications of BIOMEMS
All you need to know about the epidemiology
Asian vs. western leadership styles
All you need to know about Smart prosthesis
Analysis of Economy: Output of Goods and Services (GNP), and GDP on Economic success
A Guide to Pricing Strategies
An Overview Of Economic Studies
Analysis of Fiscal and Monetary Policies
Analysis of Business Cycles
Analysis of Consumption and Investment
A Look into Regression Analysis
Analysis of Household's Consumption and Savings Behavior
All you need to know about Capital Budgeting
All you need to know about risk management
Art looted in wartime.
Appropriate use of Data in Economics
All you need to know about reaction kinetics?
A historical overview of Financial Crises
All you need to know about management discipline?
An insight into the error-correction models
All you need to know about Data visualization
All you need to know about Work-family balance
All you need to know Technical Writing?
All you need to know about digital special effects
All you need to know about Big data management
All you need to know about Neuroendocrinology
How to Write a Personal Essay
Housing Needs in America
How to Write a Description Essay
How to Create an Excellent Scholarship Essay?
How to write a cause and effect essay
How to Hire the Best Essay Writing Service Provider?
How to Write a College Application Essay?
How to get the most out of your English lectures
How to write Expository Essay
How to succeed in your psychology class?
How to Write an Academic Essay in the Shortest Time?
History of Journalism
How Different Sectors are Using Artificial intelligence (AI)
How to write an informative essay
How to deliver persuasive essays?
How to Give a Convincing Presentation
How to write an essay on leadership?
Historical Art Still Around Today
Humanoid robot: what it is, how it works and price
History of Chemistry
Healthcare Advanced Computer Power: Robotics, Medical Imaging, and More
Healthcare AI: Game Changers for Medical Decision-Making and Remote Patient Monitoring
How to understand different types of English
How to Cope with Chronic Pain
How African American choreographers and dancers have influenced American dance
How mobile robot can do in logistics or in production
How To Become a Successful Entrepreneur
History of the Philosophy of Feminism
How is the climate changing?
How to Track Your Content Marketing ROI
How to Gun control In the USA?
Historical and contemporary role of labour in the modern world
How breast cancers are classified?
How the cells of our body communicate?
How the Lymphatic System Works?
How Digestive System Works
How to complete your capstone projects effectively?
How to write a research project
Healthcare technologies that help patients with better self-management
How to choose the topic of the senior capstone project
How to make your business survive at economic crisis
How can immigrants blend in the American society?
How does the economics of war affect society?
Hate speech on social media.
How to Build an Economic Model
How to start a healthcare startup?
How can financial illiteracy harm you?
How cancer is developed - Cancer biology
How to define the Enterprise Value
How to conduct economic research?
How women can manage sexual harassment
Introduction to Urban Studies
Importance of dance in education
InMoov: how to build an open source humanoid robot
Importance of KYC verification to making the Blockchain secure
Importance of Rhythm
Importance of dance student evaluation
I/O control methods -types and explanations
Identity theft: what to do?
Introduction to Utilitarianism
Importance of 3d Modelling in Architecture
Importance of online journalism
Image processing in medical diagnosis
Introduction to USA Politics
Introduction to Comparative Politics
International Relations as a Major in Political Science
Importance of modern trade policy
Introduction to Journalism
Introduction to Writing a TV Script
Introduction of Microfabrication techniques
Introduction to Microeconomics
Interaction of Consumer and Firm Choices in Markets
Importance of corporate sustainability
Issues in International Monetary Macroeconomics
Introduction to Statistics and Data for Economics
Introduction to Data and Probability for Economics
Introduction to the Game Theory
Introduction to Econometrics
Introduction to Economic Information
Introduction to Market Equilibrium
Introduction to Economic Models and Application
Introduction to Empirical Research
Introduction to Econometric Data
Importance of Critical Thinking, Principles, and Goals
Introduction to Identification and Causal inferences
Introduction to Econometric Application
Intermediaries and Government in Financial Crisis
Importance and seven principles of quality management
Illiteracy in the USA
Introduction to Economics of Law
Introduction to Coase Theorem
Introduction to Social Choice and Incarceration
Intellectual Property and Product Liability
Investment in Human Capital
Introduction to Labor Markets
Imperfect Information in Insurance
Imperfect Information and Asymmetric Information
The Looming Energy Crisis in America
Top benefits of performance-based engineering
The More Languages You Know, The More Times You Are a Man
Things to consider while writing an Argumentative Essay
Top Ways to Improve Your Academic Writing Skills
Tips to Excel in Creative Writing
The origins of films in the early 19th century
Top career options in Architecture
The Elevator Pitch
Top finance trends 2020
The basic Structure and functionality of robots
The Way to Success
The election system of the President in the United States of America
Two-party System in United States of America
Top trends in urban design
The history and theory of African American filmmaking
Top benefits of creative writing
Tinnitus Guide: Common Symptoms and Treatment Options
The language of dance
The digital image processing management
Top famous politicians of the World
Top methods of political science!
The history of the feminist movement
The blood flow in cardiovascular system - Biofluid Mechanics
The best of Leonardo Da Vinci
The Structure and Function of Macromolecules
The structure of cell: a research on the bricks of the human body!
Tissue and organ construction: Adhesion and recognition between cells
The kinetics of the transformation processes
The Modeling of Biological Systems
Tips for writing a great thesis statement
The Defense mechanisms against infections
The impact of the technological innovations in medicine
Top journalism trends to know about
The relation between mass media & politics
Theranostics: Diagnosis and Care through Nanoparticles
The practical Applications of X-rays
The applications of Ultrasound in medicine
Transfer mechanisms of genetic information in Bacteria
The regulation of cellular metabolism in the diagnosis
The Principles of MRI Contrast agents
The technical basis of optical coherence imaging
The New Media: Emerging Trends
The Structure of Interest Rates and the Yield Curve
Technological perspectives and reflections of neural engineering
Types of bioreactors and their applications
The Role of Government Policy in Improving Economic Outcomes
Types of corporate responsibility
The Role of IMF in International Monetary Macroeconomics
Tools for investment decision making
The concept of Organizational Culture and its applications
The Conduct of Monetary and Fiscal Policy
The Basics of Financial Accelerator Models
Tips for labeling medical devices- Medical Entrepreneurship
The different medical imaging techniques
The Economics of Uncertainty – Introduction
Theories of Public Policy
The Game Theory in Social Media
The political theory of Thomas Hobbes
The Use of Law on Economics and Vice Versa
The Role of Internal Audit in Corporate Risk Management
What is a Definition Essay?
What are diagnostic essays?
What is the relation between art structural engineering?
What is a Narrative Essay
What are robotics and intelligence systems?
What are the benefits of studying health sciences?
What is artificial intelligence and why it matters?
What is comparative Literature?
Why study neuroscience
What is Wi-Fi and how does it works
What is French history famous for?
What are Humanistic Studies?
What is covered in Biophysics?
What is modern journalism?
What is Virtualization? Benefits & Applications
What are modern public relations?
What is plasma physics?
What is teacher preparation?
What is rapid prototyping for 3D printing?
What is contemporary European Politics?
Why should you learn American Ballet?
What is engineering physics?
What is the purpose of African American Literature?
Ways to learn the Rhythm
What is digital art used for?
What are Enzymes and how do they work
Who is the father of political science?
Why Study Political Science - Job?
What is the Philosophy of Feminism?
What is a quantum computer?
Ways B2B Startups Streamline Their Conversion Strategies
Why do biomedical signals need processing?
What are the long term effects of climate change?
Why study labour relations
What is Holoprosencephaly?
What is antisocial disorder?
What are the important principles of evolution?
What is the cytoplasm and its function?
What is biopolymers?
What Makes a Good Leader
Women empowerment in modern generation
What is the history of political thought?
What is Gene recombination
What is synthetic biology
What is business cost analysis?
What is Inflation
What are the consequences of unemployment?
What is lithotripsy and its types?
What is transition elastography?
What is the purpose of deep brain stimulation?
What is a Brain-Computer Interface (BCI)
What is neuroethics?
What is Market and Supply and Demand
What is optogenetics?
What are the techniques to record brain activity?
What happens if the interest rate increases?
What is immunotherapy?
What is the economic role of the financial market?
What are the factors behind illegal immigration?
What is the lymphocyte activation?
What is financial market and its types?
What is the structure of financial markets?
What are the methods of measuring business performance?
What is the Credit market?
What is business ethics and code of ethics
What are the Causes of financial instability?
What is MBA with Concentrations
What is regenerative medicine?
What is Population ecology?
What is Microfinance: evolution, and practices?
What is biotechnology and its applications?
What are Workplace diversity and its benefits?
What is the difference between a leader and a manager?
What Is Branding and best branding Business strategies?
Why are microelectronics important?
What are biologic drugs.
What is the Foreign Exchange market?
What is the role of scientific research in times of crisis?
What are the risks of international trade?
What is financial management?
What is gene therapy?
What is education economics?
What is regression analysis, and why should you use it?
What Is Technology Marketing And How Should It Work?
What is Management Accounting
What are the methods of valuation of companies?
What is Immune System and Immunotherapy?
What is big data analytics?
What is the 7 layers of OSI model?
What is Neuroplasticity?
What are Sculpture art and its types?
What are the different genres of films?
What is Transcranial magnetic stimulation (TMS)?