Background of the study

The purpose of engineering investment is to acquire acceptable returns however these decisions

can be affected by substantial uncertainties. These absences of assurance could be due to the fact that the

revenue solely depends on the study and control of these uncertainties. Investment decision making is a

key management task in a sense that it plays an essential part making it as the starting point in the entire

investment process.

Significance of the study

The study aims to familiarize the evaluation processes used to determine viability in investment

decision making and techniques which includes ranking, payback period, average rate of return, net

present value and internal rate of return.

Discussions

Investment decision is where the organization or the firm commits a substantial amount of money

or resource to a certain course of action which is usually referred to as capital investment. The focus

being on the strategic capital projects concentrates on the distribution of a firms long term capital

resources.

Managers usually sees profit as the measurement of performance. It can be assumed that capital

project appraisal should be pursued to evaluate whether an investment is profitable or not.

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 Figure. 1 Possible cash flow due to an investment decision

Figure 1 shows a typical cash flow situation wherein during the first 2 years the amount of

money invested have no any returns. During the third year, the investment had some payback. The

amount of returns continues to grow as the year progresses and at some point, cumulative sum of the cash

received surpasses that spent in the preceding years. There are however complications with the profit

measure for evaluating future investment performance since profit is based on principles of accounting of

income and expenses linking to a particular accounting period based on the matching principles meaning

that the income receivable and expenses payable, not yet paid or received, with depreciation charges,

comprises part of the calculation for profit. Decision making can be regarded as an incremental activity.

Normally businesses operate as going concerns with explicit strategies and a reputable management

processes. Decisions are a portion of sequence of actions to make the organization move to its envisioned

position.

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 Managers are required to make essential investment decisions examples of these are investment

in machinery or upgrades and advancement to current equipment. This type of investment is necessary to

increase production capacity and make processes cost-effective so as to decrease costs in manufacturing.

Equipment have to be depreciated and typically have an end value. It also has maintenance costs however

the revenue will be produced instantly by their usage. Investment in Research and Development is

another type of investment wherein development of new products are conducted. Commonly the

expenditure in Research and Development does not necessarily involve sales but is affected by market

necessities. Research and Development costs can be fairly high and could increase as the year progresses

however the revenue is generated when the research is completed and verified and a product is

manufactured and sold. Investment in marketing, advertising and promotion is another type of investment

or as can be referred as product and service related activities. Large amount of money is expected to be

spent for it to be effective and successful in a competitive market. Another type of investment is the

investment in strategic activities. Instead of developing a product, buying-in product is executed.

However, the cost for such type of investment can be costly considering the training of staff, marketing,

badging of products and customer support activities. In all of the types of investment, it is vital to

remember that the investment itself is not the key element but is rather the profit being made.

In an investment decision, the primary activity is to select and identify appropriate investment

opportunities. Having recognized the investment prospect, defining the alternative method will be the

next step whether if it is quantifiable or non-quantifiable, parameters for these alternatives should be

determined. In the choice of project, selection of it can be based on single or multiple criterion. In an

example given by Table 1. projects have designated ranks which can be a number out of 10 or a relative

position of each other against the other as was shown in Table 1.

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Table 1. Parameters used in ranking process

The projects that achieve a rank above the minimum can then be selected. Often, the marketing,

sales and support parameters comprises of the probable market size that the product will be subjected to,

the competitiveness within the market, the influence of the new product to the present and existing

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product sold by other companies, the distribution and sales and the framework to support and maintain the

new product. For Research and Development, considerations would be the skills to develop the new

product, if any new technology is involved in developing and if the company has access to such

technology, the risks involved in developing and most of all the intellectual property rights. For

manufacturing, considerations consist of the required investment for a new equipment, new

manufacturing processes to develop a new product, labor required to make the product, storage facilities

and suppliers. Financial considerations being the most selected criterion comprises of the total cost for the

project which consists of sales, research and development, marketing, manufacturing and maintenance

and support. Another financial consideration would be the projected total sales, payback period, cash flow

and rate of return. Ranking process can spot the weaknesses of a project that needs to be considered. It

can be done as a multiple process e.g projects are selected first and those that need lower investment can

be short-listed and the best within the criteria of a company is chosen. A case study is shown below to

further understand situations regarding the ranking process and dealing of the circumstance.

Case Study:

One out of three

On the board of the company wish to develop a product to complement their existing products.

Three potential new products have been identified and the Board have to choose between these, since

investment is available for only one product.

In order to aid in this selection process a list of parameters has been drawn up specialists within

each function have been asked to rank the three projects again each parameter, with 1 being the worst and

3 the worst. Table 1 is used for reference.

Product B has the largest potential market size, although it is also the one with the highest number

of competitors. The market trend favours Product A which has the fastest market growth rate of the three.

Product B will have the greatest impact on the companys existing products, since it will compete with

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some of them in certain market sectors. Product C is the best match with the companys existing

distribution and sales channels, while Product B best fits its support structure.

Different aspects of R&D favoured different products. Product A requires new R&D skills,

although it involves development of the largest amount of new technology and therefore represented

higher risk. In spite of this Product A is also the best regaring Intellectual property rights, in that the

company owns most of the intellectual property rights associated with the new technologies involved.

Product A requires very little new manufacturing plant, although new processes are involved.

Labour skills availability favours Product B along with the availability of suppliers of raw materials and

finished goods.

In financial considerations Product B needs the lowest overall investment (lowest cost), whereas

Product A shows the highest expected sales volume and the shortest payback period. In spite of this the

cash flow position is slight better with Product B, as also is the discounted rate of return.

Based on this assessment the Board decide that Products A and B should be investigated further

since they have the scores that are close together and are better than Product C.

Another investment technique used by managers on approaching investment decisions is the

payback period. It is defined as the period of time taken for the future net cash inflows to match the initial

cash outlay.

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 Figure 2. Payback period

Figure 2 demonstrates an example of how a payback period analyzed. A substantial expense in

the initial investment is assumed and increases with time as is shown in the figure. The return being also

the same as the time of the initial investment also increases with time. And after some time, a payback

period is met wherein the total return exceeds the total investment. An example of calculation for payback

period is shown below

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 Figure 2. Payback period

It is shown that Laras cumulative cash flow for 2 years has reduced to -8000 but by the end of

the third year it has enhanced having +8000. It can then be stated that the project breaks even or pays

back in 2.5 years. Comparing in Carlings situation, it breaks even for 2.9 years. If the requirement of a

company is to have a payback within three years, both Lara and Carling cash flow would be acceptable.

Certain advantages can be described in payback method, firstly it is easy to comprehend and is good for

situations where changes are likely to occur and is a good method especially if a company prefers projects

which breaks even early. However, there are disadvantages also regarding the payback period in which it

does not consider time factors in investments and returns not considering the discounts and that money

will vary over time and that no considerations on future plans after a payback is met.

The average rate of return is an investment technique wherein it is calculated as the average

return during period over the total investment during period expressed as percent.

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 Average return duringthis period
ARR = x 100
Total invesment during this period

Equation 1. Formula for ARR

Advantage for using the average rate of return method would be that it is easy to comprehend and

it considers all investments and returns over the products lifetime. Same as the payback period, the

drawback in the said method is that it does not consider the effects of time and it considers only

percentage and not absolute values.

Before going further on discussing other investment techniques it is important to first understand

the concept of discounting. It can be explained as a money is worth less than its amount today. An

example would be that if a person has to make a choice between receiving a $100 today or 100$ next

year. Obviously, the choice would be the former for two reasons. Firstly, the future is uncertain and the

doubt that if the $100 could be received next year. Secondly, even if there is certainty in receiving the

money in the future a wise decision would be to choose the former decision in which receiving the money

today since it can be invested and earn interest say at 8%. One year after the $100 today will become

$108 next year whereas if the latter choice is made in which receiving the money next year, same amount

of $100 would just be received. To find out how much $100 will be worth in the next year a formula is

applied as shown below.

A
PV = n
x 100
(1+i)

Equation 2. Formula for PV

PV being the present value A as the amount today, i is the rate of interest and n is the number of

years. Calculating for $100 and an interest of 8%, the value of it after 1 year would be $92.59. Therefore,

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in making a decision in an investment, it is important to consider and analyze the net present worth and

can be stated as follows If a decision affects costs and revenues at future dates, it is necessary to discount

those costs and revenues to present values before a valid comparison of alternatives is possible. Two

methods are used in the Discounted cash flow. The net present value and the internal rate of return which

will be discussed accordingly.

It has been assumed that the goal of a company is to generate as much money as possible for its

owners through efficient usage of resources. For it to materialize, the present value of all future cash

inflows must exceed the present value of all expected cash outflows. Decisions include costs and benefits

wherein the initial expense consists of the cash paid to the supplier of the asset and any other costs

involve in making the project. The problem occurs in measuring the worth of the investment project since

an assets worth may have little to do with what it cost. To determine the worth, it is important to consider

the value of the current and future benefits less costs from the investment. Since it is almost impossible to

quantify benefits, investment decisions involve initial capital expenditure followed by a stream of cash

receipts and disbursements in subsequent periods. The net present value method is applied to analyze the

investment opportunity which can be defined as

n
X
NPV = I
t=1 ( 1+ k )t

Equation 3. Formula for NPV

where x is the net cash flow, I is the initial cost, n is the projects life and k is the minimum

required rate of return on the investment or the discount rate. The elements of investment appraisal is

shown below.

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 Figure 3. Investment appraisal elements

To further understand the Net Present Value, an example is shown below.

The management of Gazza Ltd is currently evaluating an investment in hair dye products costing

10,000. Anticipated net cash inflows are 6,000 received at the end of year 1 and a further 6,000 at the

end of year 2. Assuming a discount rate of 10 per cent, calculate the projects net present value. We can

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compute the NPV for Gazza using three different approaches, all of which will be employed in later

chapters.

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 This approach is appropriate only when annual cash flows are constant. Notice that the present

value interest factor for an annuity at 10 per cent for two years (taken from Appendix D) is simply the

cumulative total of the individual factors in the previous approach. How would the net present value

differ if the perceived project risk were greater? The risk-averse management of Gazza would probably

require a higher return from the project, reflected in a higher discount rate. Repeating the exercise using

13 per cent (average risk) and 16 per cent (high risk).

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 Looking at the net present values, what interpretation can be made? With a 10 per cent discount

rate, the project offers a positive NPV of 413. If the projected cash flows are generally expected to be

achieved, the market value of the firm should rise by 413. Hence, the project should be accepted. On the

other hand, if the project is classified as high risk, the cash inflows are discounted at a rate of 16 per cent

and the NPV is estimated at 369. Its acceptance would reduce the firms market value by 369. Hence,

the project should not be accepted. Clearly, it would not be wise to exchange 10,000 today for future

cash flows having a present value of less than this amount.

If the project is classified as having average risk, the discount rate used is 13 per cent, yielding an

NPV of 8. The project is just acceptable; it yields 13 per cent, which is the required rate of return. We

can draw two important conclusions: 1 Project acceptability depends upon cash flows and risk. 2 The

higher the risk of a given set of expected cash flows (and the higher the discount rate), the lower will be

its present value. In other words, the value of a given expected cash flow decreases as its risk increases.

Case Study:

A company decided to invest 10,000 in one of two projects, each of which gave a different level

of profits over the next five years, as shown in the third and fourth columns in the table below.

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 Year PV factor Project 1 Project 2
(10%) Profit PV of profit PV PV of profit
1 0.9091 2000 1818.2 4000 3636.4
2 0.8264 3000 2479.2 5000 4132.0
3 0.7513 4000 3005.2 2000 1502.6
4 0.6830 4000 2732.0 1000 683.0
5 0.6209 2000 1241.8 1000 620.9
Total 15000 11276.4 13000 10574.9
Table 2. Illustration for project selection

In order to select one of the projects the present value of the profits was calculated using the

companys return requirements of 10 per cent. From the table, it can be seen that Project 1 has an NPV of

11276.4 - 10000 = 1276.4, and Project 2 has an NPV of 10574.9 - 10000= 579.4. Both projects

have a positive NPV and so either can be selected. However, Project 1 has a higher NPV, so if no other

criterion is used for project selection then this is the one that should be selected.

In the internal rate of return, it can be defined as the rate in which it equates the present value of

future benefits to the initial cash outlay. IRR is where the discount rate, represented by r, if applied into

the project cash flows, represented by X. yields a zero net present value. It can be solved using the

formula

n
X
( t
=0
t =1 1+ r )

Equation 4. Equation for solving r

If the IRR surpasses the needed rate of return in which r is greater than k then the project is

acceptable. For a further explanation on the application of IRR, two sample problems are presented below

and a case study is provided

A machine can reduce annual cost by $40,000. The cost of the machine is 223,000 and the useful

life is 15 years with zero residual value.

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 Required:

1. Compute internal rate of return of the machine.

2. Is it an acceptable investment if cost of capital is 16%?

Solution:

(1) Internal rate of return (IRR) computation:

Internal rate of return factor = Net annual cash inflow/Investment required

= $223,000/$40,000

= 5.575

Now see internal rate of return factor (5.575) in 15 year line of the present value of an annui

ty if $1 table. After finding this factor, see the corresponding interest rate written at the top of the

column. It is 16%. Internal rate of return is, therefore, 16%.

(2) Conclusion:

The investment is acceptable because internal rate of return promised by the machine is equal to

the cost of capital of the company.

Total amount invested is Rs 70000. Net income earned for first year is Rs 12000. Net income

received for second year is Rs 15000. Net income earned for third year is Rs 18000. Net income received

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for fourth year is Rs 21000. Net income for the fifth year is Rs 26000. Find out IRR from the given

values?.

Invested Amount = 70000

Net Income derived

1st yr - 12000

2nd yr - 15000

3rd yr - 18000

4th yr - 21000

5th yr 26000

Solving for the IRR,

IRR = 8.66%

Case Study:

A company was to consider a proposal to invest 1,000,000 in a new project which is expected to

yield 300,000, 400,000 and 500,000 over the next three years.

The minimum yield expected from projects is 10 per cent and a Financial Director, has been

asked to determine the IRR for this project.

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 In order to find the yield at which the profits discount to the original investment of 1,000,000

(i.e NPV equals zero), the Financial Director takes two discount rates, 5 per cent and 15 per cent and

calculates the NPV as shown in table 3. From it, the director sees that 5 per cent yield the NPV is positive

and for 15 per cent yield it is negative. The director therefore knows that the IRR lies between 5 per cent

and 15 per cent

Year Profit 5% rate Project 2

PV factor PV of profit PV factor PV of profit

(000) (000)
1 300 0.9524 286 0.8696 261
2 400 0.9070 363 0.7561 302
3 500 0.8638 432 0.6575 329
Total 1081 892
Table 3. Calculation for the IRR

He can plot the two points (1081, 5) and (892, 15) on a graph to find when they pass through

1000, or he can calculate it from the equation for a straight line passing through these points. The

financial director finds the equation of the straight line as shown in equation 5 where Yield is in per cent

and PV in thousands.

PV = -18.9 Yield + 1175

Therefore, for a present value of 1,000,000 the value of Yield is found as 9.3 per cent. The

Financial Director presented it to the board with the recommendation that the proposal be rejected, since

it did not meet the companys minimum investment criteria.

Investment decisions 18 | P a g e
Conclusion

In investments, certain risks cant be avoided especially if large amount of money is involved

since there is no guarantee if a benefit can be acquired in such decision. These kinds of investments can

be an investment in a new plant or a new machinery, for research and development for a new product or

new technology, it could be an advertising program or a marketing program to sell the product and further

improve the companys image or as a strategic investment for buying products or taking over another

company.

In a company, there are several projects being proposed and a competition for a financial

investment is typical. In such cases, techniques regarding if a proposed project is appealing can be used.

Benefits and the amount of return are all assumed in the techniques that will be used.

In the ranking method of project selection, a systematic approach in ranking is used depending on

the parameters for the project being evaluated. The selection criteria, and the allocation of ranking are

done by specialists in the various areas to ensure that the selection is made objectively.

Payback period it can be a useful method, but ignores cash flows beyond the payback period.

Simple payback also ignores the time-value of money. Such assessment is good if a swift change occurs

or is likely to occur for example like in technology where it changes so fast that an investment today to

such technology would be obsolete in the next few years. It is because payback period technique prefers

projects that have early return or payback.

Investment decisions 19 | P a g e
 Average rate of return (ARR) compares the average profit of the project against the book value of

the asset acquired. Its main merit is that, as a measure of profitability, it can be related to the accounts of

the business. However, it takes no account of the timing of cash flows or of the size and life of the

investment.

The net present value (NPV) method discounts project cash flows at the firms required return

and then sums the cash flows. The decision rule is: accept all projects whose NPV is positive.

The internal rate of return (IRR) is that discount rate which, when applied to project cash flows,

produces a zero NPV. Projects with IRRs above the required return are acceptable. The NPV approach is

viewed as more sound than the IRR method because it assumes reinvestment at the required return rather

than the projects IRR.

Investment decisions 20 | P a g e
kjReferences

Liu, Y., Yi, T.H., Wang, C.Q. (2012) Investment Decision Support for Engineering Projects Based on Risk
Correlation Analysis. Retrieved from https://www.hindawi.com/journals/mpe/2012/242187/

Pike, R., Neale, B. (2009) Corporate Finance and Investment: Decisions and Strategies (Prentice Hall

Europe).

Lessard, D. (1985) Evaluating foreign projects: An adjusted present value approach, in D. Lessard (ed.)

International Financial Management (Wiley).

Horngren, C.T., A. Bhimani, G. Foster and S.M. Datar (1998) Management and Cost Accounting

(Prentice Hall Europe).

Fama, E. and K. French (2004) The CAPM Theory and Evidence, Journal of Economic Perspectives,

Vol. 18, No. 3, [Summer], pp. 2546.

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