Analyze and make recommendations on competing investment opportunities. Make effective oral and written communicationsIntroduction: The capital investment decision making process is tightly coupled with the company’s strategic planning. Strategy would shape the choice of investment projects and in turn the choice of projects would dictate the company’s future strategic decisions. While important in themselves even the most rigorous financial analysis tools cannot capture the strategic dimensions that are inherent in any given capital investment project. Keeping this inherent fact in mind one could arrive three basic processes that could be used for an analysis of the financial viability of a given project at a given point in time.
Capitral Investment: DCF, Payback and ARRCapital investment or capital expenditure means spending money now in the hope of getting it back later through future cash flows (Ahadiat and Brueggemann, 1990). Most investment appraisals consider decisions such as whether or not to invest; whether to invest in one project or one piece of equipment rather than another and whether to invest now or at a later time. There are three main methods of evaluating investments: Accounting rate of returns, payback and discounted cash flow (DCF).
For a given project, investment appraisal requires estimation o future incremental cash flows, that is, the additional cash flow or the net income less expenditures that would result from the investment, as well as the cash outflow for the initial investment (Allen, 1961). Depreciation is of course an expense in arriving at profit which does not involve any cash flow. Cash flow is usually considered to be more important than accounting profit in investment appraisal given the fact that it is cash flow that drives shareholder value. DCF capital Investment appraisal method: Despite the apparent lack of sophistication of techniques like DCF capital investment decisions are often made subjectively and then justified after the event by the application of financial techniques (Hartley, 1990).
Shank (1996) used a case study to show how the conventional net present value (NPV) approach was limited in high technology situations as it did not capture the richness of the investment evaluation problem. He saw NPV more as a constraint than a decision tool given the fact that it was driven by how the investment proposal was framed.
He also argued that a strategic cost management approach could apply value chain analysis, cost driver analysis and competitive advantage analysis to achieve a better fit between investment decisions and business strategy implementation. The first method that is to be used in the calculation of investment validity is the discount cash flow method wherein stress is laid on the timing of the cash and not the profit for arriving at the capital investment appraisal. The idea in essence is that cash outflows are outflows of money that is given by the investor to the business, and on which a return on investment is required while the money is still in the process of it remaining invested.
The idea therefore is that the faster the cash is recovered the more would be its equivalence to the given present value of the money invested and therefore it would have the better return on the investment made. The method is inclusive of the implementation of the principles of application discount arithmetic to the estimated future cash flows from a capital investment project, in order to decide whether the project is expected to earn a satisfactory rate of return.
The idea would therefore be to make use of the NPV method of DCF, the cost of capital which is representative of the smallest acceptable rate of return on investment as it is utilized by the discount rate so that one is able to tabulate the NPV of the cash inflows and outflows. The method gives the tabulator method provides an absolute measure of the cash surplus or deficit in present value terms (as opposed to the internal rate of return (IRR) method – not covered in this article – which provides a relative measure of project worth). The profitability of a capital investment project using NPV is determined by the relationship between the total present value of the net cash inflows and the present value of the cash invested in the project, ie whether the NPV is positive or negative.
The decision rule, using the NPV method of appraisal, is to invest if NPV > 0 (ie positive).
For the purpose of this particular appraisal one would make use of the DCF capital investment appraisal method and the payback method in order to justify the investments in both the cases thereby coming at a conclusion on the investment that would be the more profitable business of the two. In accordance with the DCF method investment at the start of the project would be £15 million over an above the cost of maintaining the hotel that would come to about 5 million at the end of the five years (Appendix 1).
The investment sum, assuming nil disposal value after five years, would be written off using the straight-line method. The depreciation has been included in the profit estimates above, which should be assumed to arise at each year end.