Investment Decisions

Prepared by: Waleed Ghazi ,SOCPA 477

MOC License no: 969055
Director MGT Reporting and Budgeting
Email: [Link]@[Link] / waleedghazi@[Link]
Mobile: 0545300021

Prepared by: Waleed October 2023 1

Ghazi ,SOCPA 477
 Investment Decision

Definition

The Investment Decision relates to the decision made by the investors or the top-level
management with respect to the amount of funds to be deployed in the investment
opportunities. The decision is made based on investment objectives, risk appetites, and
the nature of the investor, i.e., whether they are an individual or a firm.
Simply, selecting the type of assets in which the funds will be invested by the firm is
termed as the investment decision.

Goals of investment decision

The ultimate goal behind investment decisions is to maximize returns and enhance the
firm’s profit-earning capacity. Also, it ensures optimum investment to deliver value for
companies’ shareholders.

Process of investment decision

The decision-making process for investments is conceptually simple but complicated in

practice. Besides, risk assessment and mitigation is the important part of the investing
process.

The steps involved in the decision process are as follows:

1. Assessment of Current Financial Position

The first step in investment decision-making is assessing the existing financial
position. It will depict a clear picture of the current allocation of funds.

2. Set Investment Objective

The next step is to identify and select the investment objective. Here, the firms
decide between short-term and long-term investments as per the requirement.
Note: The selection must purely be a strategic decision and not based on instincts.

3. Risk and Cash Flow Forecasts

The selected investment alternatives must be evaluated considering risk and expected
cash flows. This eases the decision-making process and helps eliminate options with
lower returns.

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Process of investment decision-continues

4. Investment Criteria
Some techniques are available for selecting a suitable investment, also known as
Capital Budgeting Techniques. It determines whether to accept or reject the
investment alternative proposal.

5. Future Course
At last, the firms need to examine the investment performance and related events
constantly. For example, the effects of the investment made on the firms working
capital.

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Investment Types

Investment decisions are categorized under two heads based on the duration of the
investment. This is because, returns generated differ in the short and long term.

1. Long-term Investment Decisions (Capital Budgeting)

These decisions are popularly known as Capital Budgeting Decisions or Capital

Investment Decisions. This is because, it involves the investment in fixed or capital
assets. These decisions are crucial because any wrong decision may endanger the firm’s
existence.

2. Short-term Investment Decisions (Working Capital Management)

The investment made in the current assets or short-term assets is termed as Working
Capital Management. The working capital management deals with the management
of current assets that are highly liquid in nature.

These decisions affect the firms’ earning capacity, profitability, liquidity, and solvency.
Cash management and inventory control are important parts of such decisions.

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Capital Budgeting Process

Introduction:
Capital budgeting process is the process of identifying , analyzing, and selecting
investment in long-term projects.

By their nature, capital projects affect multiple accounting periods and will constrain
the organization’s financial planning well into future .

Capital budgeting applications include :

• Buying equipment
• Building facilities
• Acquiring business
• Developing a product
• Expanding into new market

Factors affecting capital investment decisions are:

• Expected Cash Flow
• Rate of Return
• Investment Criteria

Stages in Capital Budgeting :

There are six stages in capital budgeting:

1. Identification and definition. Those projects and programs that are needed
to attain the entity’s objectives are identified and defined. The projects and
programs determine their extend and facilities cost, revenue, and cash flow
estimation. This stage is the most difficult.
2. Search. Potential investments are subjected to preliminary evaluation by
representative from each function in the entity’s value chain.
3. Information-acquisition. The cost and benefits of the projects that passed
the search phase are enumerated.
4. Quantitative financial measures are given the most scrutiny at this point.
These include initial investment and periodic cash inflow.

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Stages in Capital Budgeting-continued

5. Nonfinancial measure, both quantitative and qualitive, are also identified

and addressed. Examples include the need for additional training on new
equipment and high customer satisfaction based on improved product quality.
6. Selection: Employing one of the selection models(net present value, internal
rate of return, etc.)and relevant nonfinancial measures, the projects that will
increase shareholder value by greatest margin is chosen for implementation.
7. Financial. Source of funds for selected projects are identified. These can come
from company operation, the issuance of debt, or the sales of company’s stock
8. Implementation and monitoring: once projects are underway, they must
be kept on schedule and within budgetary constraints

Steps in ranking potential investment

Capital budgeting requires choosing among investment proposals .Thus, a ranking

procedure for such decision is needed. The following are the steps in ranking
procedure:

1. Determine the asset cost or net investment

• The net investment is the net outlay , or gross cash requirement, minus cash
recovered from the trade or sale of existing assets , with any necessary
adjustments for applicable tax consequences .
• The investment required includes funds to provide for increases in net working
capital. For example , the additional receivables and inventories result from
acquisition of a new manufacturing plant. The change in working capital is
treated as initial cost of the investment (a cash outlay).

2. Calculate estimated cash flows,

• Period by period, using the acquired assets.

• Reliable estimate of cost saving, or revenue are necessary.
• Net cash flow is the economic benefits or cost, period by period.
• Economic life is the time period over which benefits of the investment proposal
are expected to be obtained.

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Steps in ranking potential investment-Continued

• Depreciable life is the period used for accounting and tax purposes over which
cost is to be systematically and rationally allocated. Because depreciation is
deductible for income tax purposes, thereby shielding some revenue from
taxation, depreciation gives rise to a depreciation tax shield.

3. Relate the cash flow benefits to their costs by using one of several methods
to evaluate the advantage of purchasing the assets.

4. Rank the investment.

• A firm hurdle rate is the minimum rate of return in a project or investment that
an investor is willing to accept.
• The risker project, the higher the hurdle rate.
• The lower the firm’s discount rate, the lower acceptable hurdle rate.
• A common pitfall in capital budgeting is the tendency to use the company’s
current rate of return as the hurdle rate. This can lead to rejecting projects
that should be accepted.

Cash flow

Relevant cash flows are much reliable guide when judging capital projects because
only they provide a true measure of a project to affect shareholders value.

1. Net initial investment

➢ Cost of new equipment

➢ Initial working capital requirement
➢ After-tax proceeds from disposal of old equipment.

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Cash flow-continued

2. Annual net cash flows

➢ After-tax cash collection from operations (excluding depreciation effect)
➢ Tax saving from depreciation deductions (depreciation tax shield)
➢ The amount which depreciation shield or protects the taxpayers from
income taxes is the applicable tax rate multiplied by the amount of
depreciation (Depreciation expense * Tax rate).Tax shield an important
component of the decision when making investment decision.

3. Project termination cash flow

➢ After-tax proceeds from disposal of new equipment.
➢ Recovery of working capital(untaxed).

Other consideration

Other consideration in capital budgeting includes the following:

➢ Effect of inflation in capital budgeting.

➢ Post-Audit should be conducted to serve as control mechanism and to deter
managers from proposing unprofitable investment.
o Actual-to-expected cash flow comparison should be made. And
unfavorable variance should be explained.
o Individual who supplies unrealistic estimates should have to explain
differences.
➢ Qualitive consideration include the following:
o The effect of the environment an option may not have the highest return
but might benefits the environment.

o Additional job opportunities that may be created in the community.

o The overall growth strategy for the company might be enhances by
accepting a project that will initially generate a loss or lower gain than
alternatives.

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Risk Analysis and Budgeting Process

Risk analysis attempts to measure the likelihood of the variability of future returns
from the proposed capital investment. The following are used to analyze or account
for risk.

Informed method. NPVs are calculated at the firm’s desired rate of return. And the
possible projects are individually reviewed.
If the NPVs are relatively close for two mutually exclusive projects, the
apparently less risky project is chosen.

Risk-adjusted discounts rates. The discount rate of capital investment is generally

the company’s cost of capital.
However, when a capital investment is more or less risky than normal for a company
it’s discount rate is adjusted accordingly. The discount rate is increased (above the
company cost of capital) for risker project and decreased (below the company’s cost
of capital)for less risky projects.

Thus, discount ratee may vary among capital investment depending on the company’s
cost of capital and the type of investment.

Simulation analysis. This method represents a refinement of standard profitability

theory. The computer is used to generate many examples of results based upon
various assumptions.

Sensitivity analysis. Forecasts of many calculated NPVs under various assumptions

are compared to see how sensitive NPV is to changing conditions. Changing the
assumptions about certain variable or group of variables may drastically alter the
NPV. Thus, the asset may appear to be much risker that was originally predicted.
Sensitivity analysis is simply an iterative process of recalculated return based on
changing assumptions.

Scenario analysis. The profitability of a capital investment is analyzed under various

economic scenario.

The Monto Carlo Simulation is used to generate the profitability distribution of all
possible outcomes from a capital investment

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Real Option
Real options are options to modify the capital investments.

Real options are not measurable with the same accuracy as financial option because
the formulas applicable to the latter may not be appropriate for the former.

Management accountant should be able to determine what real options are embedded
in a project, to measure their value, and to offer advice about structuring a project to
include such options. The following are among the types of real options;

Abandonment of a project entails selling its assets or employing them in an

alternative project. Abandonment should occur when, as a result of an ongoing
evaluation process .

The option to delay allows the options holder to postpone implementation of the
project without losing the opportunity.

The option to expand allows the option holder to move forward with or expand a
project after the initial stage has been implemented.

The option to scale back allows the option holder to shrink a project after the initial
stage has been implemented.

Risk tolerance and the Certainty Equivalent

Risk tolerance is the acceptable degree of variability in returns.

• A company with a high-risk tolerance is willing to risk big losses for the chance
at big gains.
• A company with a low risk tolerance will avoid seeking big gains in order to
avoid the possibility of big losses.

The certainty equivalent is the big, guaranteed return that accompany would accept
over taking a risk on a higher, but uncertain, return.

• The certainty equivalent specifies at what point the company is indifferent to

the choice between a certain sum of money and the expected value of a risky
investment.

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Discounted cash flow Analysis

Time value of money

A dollar received in the future is worth less than a dollar received today.

• A quantity of money to be received or paid in the future is worth less than the
same amount. The difference is measured in terms of interest calculated using
the appropriate discount rate.
• When analyzing capital projects, the management accountant must discount the
relevant cash flows using the time value of money.

The accounting rate of return (i.e., The return divided by the investment) does not
consider the time value of money.

Present and Future Value

The present value (PV) of a single amount is the value today of some future payment.

• It equals the future payment times the present value of 1 (a factor found in
standard table) for the given number of periods and interest rate.

Annuities: An annuity is usually a serious of equal payment at equal intervals of time

for example SAR 1000 at the end of every year for 10 years.

Internal rate of Return

The internal rate of return (IRR) expresses project’s return in percentage term.

The IRR an investment is the discount rate at which the investment’s NPV equal zero.
In other words, is the rate that makes the present value of the expected cash inflows
equal the present value of expected cash flow.

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Comparing cash flow patterns

Often a decision maker must choose between two mutually exclusive projects, one
whose inflows are higher in the early years but fall off drastically later and one whose
inflows are steady throughout the project’s life .

• The higher a firm’s rate, the more quickly a project must pay off.
• Firms with low hurdle rates prefer a slow and steady project.

The NPV profile can be of great practical use to managers trying to make investment
[Link] gives the manager a clear insight into the following questions:

• How sensitive is a project’s profitability to changes in the discount rates.

• At what discount rates an investment project will still a profitable opportunity

Comparing cash flow patterns

The NPV and IRR methods give the same accept/reject decision if projects are
independent. Independent projects have unrelated cash flows. Hence, all acceptable
independent projects can be undertaken.

The reinvestment rate becomes critical when chosen between the NPV and IRR
methods.

• NPV assumes the cash flow from the investment can be reinvested at the
project’s discount rate. That is, the desired rate of return (generally the cost of
capital rate).
• The IRR method assumes that the cash flows will be reinvested at the internal
rate of return.

If one of two or more mutually exclusive project is accepted, the others must be
rejects.

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Payback and discounted payback

The traditional payback period is the number of years required to return the original
investment, that is the time necessary for a new asset to pay for itself. Note that no
accounting is made for the time value of money under this method.

Companies using the payback method set a maximum length of time within which
projects must pay for themselves to be considered acceptable.

If the cash flow are consistent, the formula is

Payback period = Initial net investment

Annual expected cash flow

The discounted payback is used to account for the time value of money

Other payback method

The bailout payback method incorporates the salvage value of the asset into the
calculation. It measures the length of the payback period when the periodic cash
inflows are combined with salvage value.

The payback reciprocal (1/payback) is sometimes used as an estimate of the internal

rate of return.

Ranking Investment Projects

Capital rationing exists when a firm sets a limit on the amount of funds to be invested
during a given period. In such situation, a firm can’t afford to undertake all profitable
projects.

Profitability Index

The profitability index (excess present value index) is a method for ranking projects
to ensure that limited resources are placed with the investment that return the
highest discounted future net cash flows per riyal invested.

Profitability Index= PV of future cash flows / Net investment

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Working Capital Management

The working capital decisions include:
• Inventory Investment
• Strategic Investment Expenditure
• Maintenance
Factors affecting working capital decisions:
• Nature of Business
• Business Cycle Fluctuations
• Seasonal Variations
• Technology and Production cycle
• Credit Policy
• Price Level Changes
• Market Competition

Nature

These decisions are generally sequential in nature. That is, it is not just a single
decision, but involves a series of decisions during the entire process. Also, the firms
may need to make a series of decisions in the future depending on the related events.
Thereby, making investing decision-making a complicated process. However, there
are techniques like decision tree analysis for such complex decisions.

Importance

Investment Decisions are crucial for firms as it deals with the most valuable resource
for the business, i.e. money. The points given below explain the importance of these
decisions:

1. Irreversible Decision: Once the money is invested, it remains blocked for a

specific period. In case of the wrong decision, the principle amount may reduce
and even become zero.
2. Substantial Amount of Funds: In firms, the money invested is usually large.
If not invested strategically, it may even endanger the firm’s survival.
3. Cash Inflow and Outflow: Investments affect both cash inflow and outflow.
Consequently, it also impacts the financial position of the firms.

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The points given below explain the importance of these decisions:-Continued

4. Profitability: The returns generated out of investments determine the firm’s

profitability. This, in turn, helps cut competition and induces the firm’s growth.

Investment Decision Maker

Generally, top-level management takes these decisions. Some firms may appoint a
designated person responsible for taking these decisions on behalf of the firms. These
persons are referred to as Investment Decision Makers.

Investment Decision Rule

Firms must consider the following rules during the decision-making process:

• Maximization of the shareholder’s wealth.

• Consider the true profitability and returns from the project.

• Choosing the appropriate decision-making technique.

• Assure the regularity of cash flows.

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Common Errors
Given below are some of the errors that investors might make while taking
investment decisions:

• Wrong assessment of risk and return.

• Formulation of complicated investment policy.

• Influential decision-making.

• Naïve projections about profits and losses.

Conclusion
All in all, the correct investment decision is necessary as it affects the success and
failure of the firm. The firms must create an efficient asset base through investments.
Consequently, it will enhance the profit-earning capacity of the firm.

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