Strategic Investment Decisions Definition

Topic: Economics Words: 3100 Pages: 12 Nov 5, 2021

Introduction

Capital investment projects may be rather ‘operational’ in nature or have a more ‘strategic’ hub. ‘Strategic’ projects are important investments that involve high levels of risk, generate hard-to-quantify (or insubstantial) outcomes, and have an important long-term impact on corporate performance. Typical examples incorporate company acquisitions and mergers, the beginning of major new product lines, the installation of new manufacturing processes, the introduction of complex manufacturing and business technologies, and extensive shifts in production capability (Copeland, 2005, Abdel-Kader and Dugdale, 1998, Kayali, 2006, Arnold and Hatzopoulos, 2000, Van Cauwenbergh et al., 1996 and Slagmulder, 1997).

The difficulty and insecurity surrounding strategic capital investment projects present particular challenges to management accountants charged with their assessment (Kayali, 2006, Arnold and Hatzopoulos, 2000, Slagmulder, 1997, Abdel-Kader and Dugdale, 1998 and Dempsey, 2003). Particularly, it has been recommended that over-dependence on financial appraisal tools may bias decision-makers against strategic investment projects (Adler, 2000, Pogue, 2004 and Phelan, 1997) thus dropping their uptake and impeding the development of business innovation and potential.

Traditional Investment Appraisal Techniques Advantages and Disadvantages

For appraising the suitability, feasibility, and acceptability of the strategic options, we need firstly to assume all cash flow occurs at the end of a certain period of time usually a year. Base on this assumption, six different kinds of methods are introduced in assisting accountants considering a long-term investment.

The payback method is the simplest and frequently used method of capital investment appraisal. It is defined as the required length of time for a stream of cash proceeds from the investment to recover the original cash outlays required by investment. It has some deficiencies. It ignores the cash inflows after the payback date and cash outflows after the initial investment and also ignores the time value of money. Unfortunately, it only calculates whether the project is profitable, it can’t tell us how profitable the project is. Consequently, it is just a valid indicator of the time of getting back the initial outlay of the investment.

Discounted payback method discounts the future cash inflows to present value. Then use it to calculate the payback period.

Net Present Value (NPV) is the process of converting cash to be received in the future into a value at the present time by using an interest rate which is termed discounting and the resulting present value is the discounted present value. Pike and Wolfe (1988) showed that there appears to be a trend towards the increasing use of discounted cash flow (DCF) methods. By using the discounted cash flows techniques and calculating present value, we can directly compare the return on investment in a capital project with the alternative of equal risk in capital budgeting. However, such comparison assumes the compared projects are non-mutually exclusive with different sizes. The profitability index, which will be discussed later, is an alternative in solving this issue. The most straightforward way of determining whether a project yields a return is to calculate the NPV. This is the present value of future net cash inflows less the project’s initial investment outlays. If the NPV of the project is positive, it is acceptable from an economic perspective. It is no doubt that the most difficult is to determine the discount rate in this method.

Internal Rate of Return (IRR) is sometimes referred to as a discounted rate of return. It reflects the true interest rate earned on an investment over its economic life. That is the discount rate that will cause a zero NPV. The decision rule is that if IRR is greater than the cost of capital, the investment is profitable with a positive NPV and vice versa. Nevertheless, it assumes the organization carries enough finance to take the project. But it is not always the case because the organization may have a capital shortage in carrying out a project even if the project carries a positive NPV. It is unnecessary in using this method when preparing capital budgeting resulting from the project’s NPV summarizes all financial elements. So NPV is capable of taking over it.

Accounting Rate of Return (ARR) is computed by dividing the average annual profit from a project by the average investment cost. If the IRR exceeds the target rate of return, the project is acceptable, if not the project is rejected. In its calculation, it ignores the time value of money and gives no minimum acceptable ARR.

The final one is the profitability index. It is computed by dividing the present value of cash flows by the present value of cash outflows. A profitability index of 1 or greater represents the project is acceptable and has a positive NPV. Hence, the greater the profitability index, the greater the profitability of the project.

After appraising the strategic option, then we can select and implement the course of action. Finally, we compare the actual outcomes and planned outcomes and give a response to them if divergences occur. Two approaches can cope with the discrepancies between the planned outcomes and the actual outcomes. They are ‘what-if analysis’ and ‘sensitivity analysis’. The former is a type of analysis exploring the effect of a change in parameter on an outcome. The latter is an analysis of the effect of a change on a parameter on a decision rather than on an outcome.

In order to allow accountants to make a correct, accurate, and profitable capital suggestion, the following matters should be taken into account by taking considerable care. They are tax policy, customer taste, competitor, technology, cash flow, environmental uncertainties, finance, interest rate, industry context, etc. They are all the necessary information to be considered in making a decision in capital budgeting.

Conventional Investment Analysis Techniques

Practice in relation to the use of capital investment financial analysis techniques has been well explored (Ewert, 2008 and Adler, 2000; Kayali, 2007, McCarthy, 2003, Pogue, 2004, Pike, 1996, Abdel-Kader and Dugdale, 1998 and Arnold and Hatzopoulos, 2000). The use of ‘conventional’ investment appraisal techniques payback, return on assets or investment, internal rate of return and net present value, and risk analysis methodology (e.g. sensitivity analysis; adjustment of the payback period or discount rate), have been examined in approximately all of these prior studies.

The research findings are unpredictable, however. It is complicated to determine the degree to which these contradictions may be an artifact of the different populations, sample sizes, and matter used in the various empirical studies (Adler, 2000 and Arnold and Hatzopoulos, 2000). While assessment must be taken with caution for this rationale, the evidence seems to paint a puzzling picture of capital investment analysis practice. For example, Lefley’s (1994) study of large UK manufacturing firms stated that the most accepted investment appraisal technique was the payback procedure (used by 94% of the companies while only 69% used moreover internal rate of return or net present value). Lefley’s findings emerge to point toward a decline in the use of the complicated methods and recommended that the payback method was the most popular means of evaluating risk in advanced manufacturing technology investments a ‘strategic’ type of investment (71% use). In contrast, Pike, 1996, McCarthy, 2003 and Arnold and Hatzopoulos, 20001 reported sensitivity analysis as the most extensively used technique related to investment project risk.

Ross, 2007 and Cooper, 2001 reported that most companies use more than one financial analysis method in investment appraisal. Although they noted the extensive use of the discounted cash flow method net present value and internal rate of return, with the latter used more than the former, Abdel-Kader and Dugdale (1998, p. 273) pointed out that practitioners credited the highest importance to reasonably unsophisticated methods:

“With the exemption of discounted payback, all the measures of financial performance were seen as significant, with the primitive methods (payback and return on assets) rating slightly more significant than the complicated, discounted cashflow, methods.” Abdel-Kader and Dugdale (1998, p. 273)

On the other hand, Arnold and Hatzopoulos (2000) found that practitioners positioned the greatest stress on the discounting techniques (net present value and internal rate of return) with net present value rated high than the internal rate of return (97% of large firms used net present value; 84% used internal rate of return; 66% used payback).

These findings from key prior studies present us with disagreement, discrepancy, and an overall lack of simplicity. Also, they have often ignored the limitations of conventional financial analysis tools for sustaining strategic investment decisions in particular.

Shortcomings of Traditional Investment Appraisal Methods

Although discounted cashflow examinations have long been taken as the most effective technique for estimate investment alternatives, writers have assaulted discounted cash flow techniques for their theoretical and implementation problems in practical business contexts. As previously noted, financial project appraisals, particularly those relating discounted cash flow models, tend to be influenced towards short-term, less strategic investments whose benefits are most easily enumerated. Also, the reasonableness of such financial analyses is conciliation where techniques are inappropriately applied, cash flows are mistakenly estimated, hurdle rates are unsuitable, or important non-quantifiable project attributes are omitted (Copeland, 2005, Kayali, 2006 and Adler, 2000). Critics of conventional investment appraisal methods further disagree that discounted cash flow analysis is an insufficient and imperfect means of securing a ‘rational’ decision process in relation to strategic investments because it fails to confine ‘intangible’ project attributes and pay no attention to the value of future elasticity embedded within some strategic projects(McCarthy, 2003, Allan, 2002, Carr and Tomkins, 1996, Carr and Tomkins, 1998, Dempsey, 2003, Fama, 2004 and Busby and Pitts, 1997).

In light of these inadequacies of conventional financial analyses, it has disagreed that strategic investment projects should not be acceptable exclusively on their capacity to create economic value for the firm. Rather, a balancing evaluation of their involvement in competitive strategy is required (Pogue 2004, Fama, 2004, Chen, 1995, Putterill et al., 1996, Abdel-Kader and Dugdale, 1998 and Adler, 2000). Product quality, fit with business strategy, and enhanced competitive position are those factors recognized as important authority on strategic investment decision-making (Pogue, 2004). Yet, these hard-to-quantify benefits from strategic investments continue difficult to assess using conventional financial techniques, telling that strategic investment decision-making may need a different approach (Ross, 2007, Van Cauwenbergh et al., 1996 and Covin et al., 2001).

Observed studies (e.g. Adler, 2000, Jeffrey 2007, Johnathan, 2005, Allan, 2002 and Van Cauwenbergh et al., 1996) suggest that a ‘subjective’ decision-making procedure is often apparent in practice, with strategic factors structuring a crucial part of the decision-making input. Brealey, (2001) noted:

“In making decisions on strategic investments, quantifiable financial performance factors (whether deliberated by discounted cash flow techniques, payback period, or impact on sale and profits) were examined as of secondary significance by most respondents… product quality, fit with business strategy and improving the competitive position of the firm were the most important factors considered by all informants.”

Some authors (e.g. McCarthy, 2003 and Brealey, 2007) have noted out that recognized financial and risk analysis practices in fact have surprisingly little impact on strategic investment decisions. On the other hand, others have suggested that the greatest dependence is placed on financial analyses, whether the investment project is strategic or non-strategic in nature (Abdel-Kader and Dugdale, 1998).

Integrating Strategic And Financial Analysis

Various studies have investigated for a more refined approach to strategic investment project appraisal by integrating strategic and financial considerations (Brealey, 2001, Lefley, 1996, Putterill et al., 1996, Copeland 2005, Shank, 1996 and Adler, 2000). To this end, various analysis tools, which merge quantitative and qualitative factors, have been connected with strategic capital investment decision-making.

Value chain analysis

Value chain analysis is highly developed as a useful tool to help businesses recognize their strategically important value-creating activities and develop suitable competitive strategies (Schubert 2007, Ross, 2007 and Hoque, 2001). As such, it has the prospective to inform strategic capital investment decision-making (Shank, 1996 and Carr, and Tomkins, 1996).

Real Options Analysis

Real options analysis is a traditional financial analysis technique, such as net present value do not clearly integrate to the value of scheme flexibility (Copeland and Howe, 2002). The discounted cash flow model supposes a static environment where all capital investment decisions are reversible with no penalty—a statement that may not hold in a competitive environment. Real options analysis has been anticipated as a means of tackling this limitation of the discounted cash flow model. Derived from the financial option-pricing model (Brealey, 2001 and Jeffrey, 2007), real options analysis distinguishes that the flexibility (options) inherent in some capital projects has value. For example, options to expand, suspend, economize or abandon a major capital investment project have value for the reason that they allow a firm to respond to strategic and competitive prospects rather than remaining locked into a fixed course of action (Ross, 2007, Milis and Mercken, 2003, Busby and Pitts, 1998, Cooper, 2001, Brealey, 2007, Trigeorgis, 1997, Trigeorgis, 1999, Copeland, 2001 and MacDougall and Pike, 2003). On the other hand, projects without this flexibility have a comparatively lower value to the firm.

While real options analysis has been extensively supported for strategic capital investment appraisal (Milis and Mercken, 2003, Trigeorgis, 1997, Trigeorgis, 1999, Cooper, 2001, Ross, 2007, Benaroch and Kauffman, 1999 and Anderson, 2000), empirical support of its uptake remains thin (MacDougall and Pike, 2003) and the findings to date are incompatible. On the one hand, it has been recommended that few practitioners appreciate or use the real options approach (Busby and Pitts, 1997, McCarthy, 2003 and Bowman and Moskowitz, 2001), but other studies note that some companies have begun to draw on it in their strategic investment analyses (Coy, 1999 and Trigeorgis, 1999).

The Balanced Scorecard

Brealey, (2007) has noted that a ‘balanced scorecard’ is a set of measures that link financial measures of performance with non-financial measures (focused on customers, internal business processes, and improvement and learning), to give managers an incorporated outline for managing and evaluating their businesses. Kaplan and Norton (2001) supported the balanced scorecard as strategic management and decision-making tool, leading others to propose that a balanced scorecard approach could be gainfully applied to strategic investment decision-making (Milis and Mercken, 2003 and Lyons et al., 2003).

Benchmarking

Benchmarking has been defined as “an exploration for industry best practices that lead to better performance” (Hoque, 2001, p. 184). Benchmarking is considered a helpful tool in assisting organizations to (among other things) “promote competitive responsiveness…link operational tactics to corporate vision and strategy and trigger major step changes in business performance” (Hoque, 2001, p. 185) all areas which are connected to strategic capital investment.

Since its origins in the Xerox Corporation in the late 1980s (Camp, 1989), benchmarking has become extensively used as “one of the more admired of management fashions” (Mayle et al., 2002, p. 212). Its possible application to strategic capital investment lies in its aptitude to direct attention outside the firm towards competitors, the ‘best in class firms and modernization (Milis and Mercken, 2003). Yet, despite its extensive reputation as a strategic analysis tool, the role of benchmarking in strategic investment appraisal has yet to be studied.

Technology Roadmapping

Technology roadmapping is promising as an approach at the cutting edge of strategic decision-making advancements. It is described as “a process that contributes … to the definition of technology strategy by exhibiting the interaction between products and technologies over time” (Groenveld, 1997, p. 48) by using charts and graphs to disclose the links between technology and business needs.

A key aspiration of technology road mapping is to look both within and further than the firm to make sure that the right competence is in place, at the right time, to achieve strategic objectives (McCarthy, 2003). It, therefore, has a clear perspective for application to strategic investment decision-making, like Ross, (2007) notes:

“Technology roadmap can be used to ensure that investments in assets such as new fabrication processes, products and factory layouts, made by different sub-units of the firm, are synchronized with one another and with investments in facilitating and related technologies made by other firms…. The necessity that investments be consistent with a technology roadmap means that proponents of individual investments have to guarantee that their proposals synchronize and fit with related investments taking place within and beyond the firm in a manner that enhances value.”

While Schubert, (2007) documented widespread use of technology roadmaps in their Intel Corporation case study, published surveys of capital investment decision-making practice have yet to study the wider use of technology road mapping.

Conclusion

The significance of making sound strategic investment decisions cannot be undervalued. The right decision improves a firm’s competitive improvement; a poor one wears down it. For that reason, managers must be very cautious and premeditated in their decision-making.

In broad, managers will find two broad advances accessible for making such a decision: They can seek to overcome the shortage associated with traditional investment appraisal techniques (the “expanded financial analysis framework”), or they can embrace one of the newer appraisal techniques. A manager’s personal style and the individuality of the investment chances are factors likely to manipulate the general approach taken. Managers may have an inclination for or against financially focused appraisal techniques. The opportunity may engage in making an isolated, tangible investment for which the Research & Development method might prove suitable, or it may be intangible in nature and more acquiescent to using another method.

It has been found that the use of all financial analysis techniques is increasing with time, with the utmost growth in the use of DCF analysis techniques and more or less universal use of multiple techniques. The alternative and use of analysis techniques emerge to be independent of the type of project being assessed. That is, there is no significant difference between the use of techniques for analyzing strategic and non-strategic projects, despite the very different natures and complications of these projects. Simple is perhaps still deliberated as best when it comes to risk analysis and the interview indication suggested that risk evaluation may be supposed as a question of judgment rather than of formal analysis.

Criticisms still enfold the use of financial analysis techniques to evaluate strategic projects and the call to implement more ‘strategic’ appraisal approaches continues. It has been noted that little empirical evidence of integration and stability between strategic and financial analysis procedures. Financial analysis techniques still govern the appraisal of all categories of capital investment projects, while risk analysis procedures remain comparatively simplistic even for multifaceted strategic projects. The evolving analysis tools included in this survey register very little effect on practice. The appraisal of capital projects appears to reveal a ‘simple is best’ attitude and assurance to the responsibility of intuition and judgment in evaluating how the strategic dimensions of capital investments related to their financial outcomes.

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