An investment is an exposure of cash that has the objective of producing cash inflows in the future. The worthiness of an investment is measured by how much cash the investment is expected to generate.
The analysis of return on investment is a financial forecasting tool that assists the business manager in evaluating whether a proposed investment opportunity is worthwhile within the context of the company’s business objectives and financial constraints.
What Is Analyzed?
The investments to be analyzed have some of the following characteristics:
- A major amount of money is involved.
- The financial commitment is for more than one year.
- Cash flow benefits are expected to be achieved over many years.
- The strategic direction of the company may be affected.
- The company’s prosperity may be significantly affected if the investment is made or not made.
Why Are These Opportunities Analyzed So Extensively?
Investment decisions should be analyzed carefully because such analysis is of assistance in the decision-making process and because the decisions are irreversible, have long-term strategic implications, are uncertain, and involve considerable financial exposure.
Forecasting the future performance of a proposed investment requires the analyst to identify all the issues and effects, both positive and negative, associated with the investment. While this does not eliminate risk, it does lead to a more intelligent, better informed decision-making process. Facts and expectations based upon research and strategic thinking are incorporated into the forecast. The results of the financial analysis do not make the decision. People make decisions based upon the best available information. A capital expenditure requires significant funds and corporate commitment. It is vital that these decisions be well informed.
Operating decisions, such as scheduling overtime or purchasing larger amounts of raw materials, can be changed when the environment or circumstances change or when it becomes obvious that a mistake was made. With these decisions, the need for correction can be readily determined and the actual change can be implemented quickly, with minimal financial penalty. A capital expenditure decision, such as purchasing machinery, can also be changed. In this case, however, the financial penalty can be substantial.
Having installed equipment sit idle because customer orders dried up or never materialized can be severely damaging.
Changes in customer preferences that are not recognized before assets are purchased and installed can be even more damaging if the company cannot or is unwilling to admit the mistakes and take corrective actions. The discipline of analysis and forecasting should minimize the occurrence of this type of event.
Long-Term Strategic Implications
Locating an operation in a certain part of the country or of the world, building a factory in a certain configuration, and deciding what kinds of machines are needed and how many are all decisions that will affect the way the company conducts its business for many years to come. These decisions may very well contribute to the company’s future prosperity, or the lack of it. Companies can face such risks as:
- Critical raw materials becoming depleted
- Rail transportation service being terminated
- Manpower and/or skills shortages occurring
The discipline of the forecasting process forces companies to identify, evaluate, and resolve these risks and vulnerabilities.
The ability to predict the future is becoming more difficult and complex for businesses. Markets, customers, competitors, and technology have made the need for strategic discipline more critical than ever before.
In addition to the uncertainties and risks involved, the sheer amount of funds that must be committed to a major investment requires that all available facts and issues be identified and evaluated.
If additional debt is directly or indirectly involved, the analytical process is even more critical. Involving banks or other sources of external financing is often very helpful. Banks are risk averse businesses. They will not lend money unless they are convinced of the merits of the proposed investment. Lenders often protect their clients by identifying risks that the clients had not identified or had underemphasized. In this situation, the forecast becomes a selling document as well as a decision-making tool.
Discounted Cash Flow
The financial tool that is used to evaluate investment opportunities is called discounted cash flow (DCF). The different measurements that use this tool in some way are:
- Internal rate of return
- Net present value
- Profitability index
- Payback period
The types of investments that can be evaluated with this tool are:
- Capital expenditures
- Research and development
- Major advertising/promotional efforts
- Outsourcing alternatives
- Major contract negotiations (price, payment terms, duration, specifications)
- Evaluating new products or businesses
- Buying another business
- Strategic alliances
- Valuing real estate
On my next post: The Principles of Discounted Cash Flow, Time Value of Money Concept, Discounted Cash Flow Measures, Net Present Value, Profitability Index, Internal Rate of Return, Payback Period, Capital Expenditure.
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