FINANCIAL  MANAGEMENT

 

 

Issue

 

The chief determinant of what an organisation will become in the future is the investment it makes today. The generation and evaluation of creative investment proposals is the ongoing responsibility of all managers throughout the organisation. In well-managed companies the process starts at a strategic level with senior management specifying the environment in which the organisation will compete and determining the means of competition. Operating managers then translate these strategic goals into concrete action plans involving specific investment proposals. A key aspect of this process is the financial evaluation of investment proposals, or what is frequently called capital budgeting. The achievement of an objective generally requires the outlay of money today in expectation of some future benefits. How do we decide, first, whether the anticipated future benefits are large enough, given the risks, to justify the current expenditure and, second, whether the proposed investment is the most cost-effective way to achieve the objective?

 

Solution

 

Organisations operate by raising finance from various sources, which is then invested in assets, usually real assets. Investment involves outflows, or payments, of cash that will subsequently generate inflows, or receipts, of cash. It is the nature of things that these cash flows, both out and in, do not all occur at the same time. Often the time lag between them may be considerable. Investment opportunities that an organisation may face usually involve a relatively large outflow of cash initially followed by a subsequent stream of smaller cash inflows. Selecting which investment opportunities to pursue and which to avoid is a vital decision for management because individual projects frequently involve relatively large and irreversible commitments of finance that extend for a considerable period of time.

 

Costly and far reaching mistakes can, and probably will, be made unless great care is taken when making an investment decision. It is important to consider how such decisions should best be made and that requires a clear appreciation of the various methods that may be used in the appraisal of the opportunities that present themselves. This is the process by which organisations are able to evaluate and make decisions about potential investments.

 

There are several different models that we could use to assess investment proposals. Some are relatively simple and rely on standard accounting figures. Others, taking into account the old adage that “a nearby penny is worth more than a distant pound”, employ discounting. Nevertheless, how we go about evaluating investment opportunities partly depends on the type of decision we have to make. To begin with we should consider a quick and simple evaluation to decide whether a project is worthy of further examination.

 

After this initial screening we need to subject the opportunity to more extensive scrutiny to decide whether the project meets our investment criteria. We have a number of techniques available to us, which fall into one of two groups – those that employ discounting techniques and those that don't. The key thing to appreciate is that only discounting techniques fully recognize that money received today is more valuable than money received tomorrow because we can put it to work earlier, which makes them more appropriate for evaluating longer term investments.

 

Viewed broadly, the discounted cash flow techniques are relevant whenever an organisation contemplates an action entailing costs or benefits that extend beyond the current period. This covers a lot of ground, including such disparate topics as analysing equipment acquisitions or sales, choosing among competing production technologies, deciding whether to launch a new product, valuing divisions or whole companies for purchase or sale, assessing marketing campaigns and research and development programs, and even designing corporate strategy.

 

The evaluation of an investment project is never as simple as it, at first, may seem. Comprehending the nature of the project, understanding the events that will take place over time and predicting relevant cash flows is an awesome task in itself. Having reached that point it should not come as a surprise to know that there are many other issues that may still impact on your analysis of the situation, not the least of which are the effects of inflation, and the assessment of uncertainty and risk.

 

Inflation throws an irritating spanner into the works. Fortunately, accounting for inflation is easy in a numerical sense. The ugly dragon is treated in much the same way as an interest charge, compounding yearly. There are two important points to note. First, the effects of inflation must be compounded although do not overlook the way that it can move in opposite directions. Second, remember that inflation forecasts are subject to error. Also, published inflation rates apply to a basket of goods and services. A specific project for which a sum of money is to be set aside may suffer a totally different rate of inflation from the basket. For investment projects, particularly the more complex ones, specify carefully the assumed inflation rates and convert each future value into a current value, then perform the net present value or internal rate of return calculations on these current values.

 

Most investment decisions involve uncertainty or risk. In reality a combination of the rigour of numerical techniques with the strength of managerial experience is used to bring judgement into the analysis. Even when there is complete uncertainty about the business outlook, quantitative techniques provide a framework for thinking about the problems. Decision making becomes much tighter as soon as the uncertainties can be quantified, no matter how vaguely. Start by specifying exactly what is to be decided. This can almost always be set out in a table with the alternatives down the side and the uncontrollable influences across the top. The potential number of rows and columns is unlimited, although other techniques, such as decision trees, are better at coping with a large number of alternatives or situations. This brings order to the problem and often makes the solution seem self-evident. The body of the decision table is filled with the monetary values attributable to each possible outcome. Decision-making always requires an implicit assessment of risks. Once that assessment is explicit, the risks are quantified (on a scale of 0 to 1) and the best decision can be identified. Now it is necessary to estimate the probability of each of the possible outcomes. The probabilities must sum to 1 since one of these outcomes must occur. Of course, the best decision will vary depending on current, sometimes highly subjective, judgements.

 

This leads us to the last step where, usually because we have limited funds available for investment, we need to choose between competing projects to ensure we carry on with those that promise the greatest wealth creation. We need to rank them starting with the opportunity that provides the greatest return. To help us with this we are able to use a profitability index, the development of which is quite straightforward. We simply divide the gross present value by the initial outlay. The result is representative of each project's efficiency in terms of the capital invested at the start. This provides us with a ranking that is biased in favor of relatively productive projects, which is something we should be grateful for. If opportunities are that close as we get toward the end of our funds or resources a closer inspection of the remaining projects should ensure we select the one with the shorter duration.

 

We would be more than happy to assist you in assessing investment opportunities and creating appropriate appraisal policy and procedures. Please do email us at info@parkadvisory.uk for a free, no obligation initial consultation.