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Chapter 6

Analysis of Investment Decisions

The decision to invest resources is one of the key drivers of the business

financial system ,as we established in Chapter 1 .Sound investments that

implement well-founded strategies are essential to creating shareholder

value , and must be analyzed both in a proper context and with sound

analytical methods .Whether the decision involves committing resources

to new facilities, a research and development project, a marketing

program, additional working capital, an acquisition, or to investing in a

financial instrument, an economic trade-off must be made between the

resources expended now and the expectation of future cash benefits to be

obtained. Analyzing this trade-off is essentially a valuation process that

makes an economic assessment of a combination of positive and negative

cash flow patterns. The task is difficult because it deals with future

conditions subject to uncertainties and risks—yet this valuation principle

is common to all investments, large and small.

In this chapter, we’ll examine in some detail both the key

conceptual and the practical aspects of investment decisions, while in

Chapters 7 and 8, we’ll address the related issues of financing costs and

the choice among financing alternatives. In Chapter 9, we’ll expand on

these concepts and demonstrate how the process applies to valuing a

business and to the creation of shareholder value. From time to time,

we’ll introduce applicable portions of managerial economics and

financial theory. In keeping with the scope of this book, however, we will

avoid the esoteric in favor of the practical and useful. At the end of each

chapter, we will summarize, in s separate list, the key conceptual issues

underlying the analytical approaches covered, both as a reminder and ad a

guide for the interested reader in exploring the references listed.

The analysis of decisions about new investments, (as well as

disinvestments) involves a particularly complex set of issues and choices

that must be resolved by management. We’ll discuss these in several

categories:

 Strategic perspective

 Decisional framework

 Components of the analysis

 Economic analysis methods

Because business investments, in contrast to operational spending,

are normally relatively long-term commitments of resources, they should

always be made within the context of a company’s explicit strategy.

In addition, financial analysis underlying the decisions and the

trade-offs involved must be carried out within a consistent economic

framework of accepted and practical guidelines.

Moreover, most business investment projects have in common

several key components of analysis. These must be understood and made

explicit, as well as comparable, in order to arrive at a proper choice

among different investment alternatives.

Finally, the economic nature of the process requires that the

analytical methods supporting the decisions focus on the cash flow

impact of the investment or disinvestment.

We’ll take up each area in turn, emphasizing in somewhat greater

detail the analytical components and methodologies. Once we’ve

demonstrated the fundamental concepts, we’ll introduce certain

refinements in the analytical process. Some comments about specialized

topics will follow, and we’ll close with a checklist of key issues affecting

investment analysis.

Strategic perspective

Investments in land, productive equipment, buildings, natural resources,

research facilities, product development, employee development,

marketing programs, acquisitions, and other resource deployments made

for future economic gain should be the expression of a company’s

strategy—which management must establish and periodically reevaluate.

Investment choices should always reflect the desired direction the

company wishes to take, with due consideration of:

 Expected economic conditions

 Outlook for the company’s specific industry or business

segment.

 Competitive position of the company.

 Core competencies of the organization

An almost infinite variety of business investments are available to

most firms. It does not matter how the resource commitment is reflected

on the company’s books, in the form of an asset or as an expense for the

period –the critical point is that the outlay is being made with an

expectation of future returns. A company may invest in new facilities for

expansion, expecting that incremental profits from additional volume will

make the investment economically desirable. Investments may also be

made for upgrading worn or outmoded facilities to improve

cost-effectiveness. Here saving in operating costs are the justification.