Analyze This: Sound Investment Decisions 

Analyze This: Sound Investment Decisions: Strong financial analysis must be coupled with strategy and sound judgment when evaluating investment decisions 

By John McCarthy, CPA

It's a problem faced daily by top financial pros across most industries: How do you make the most of your investment capital?

In the mutual fund, commercial banking and venture capital worlds, the investment decision-making process is often detailed and disciplined, with extensive review of each security purchased and every loan approved. A finance chief sets criteria, and each investment must meet those criteria to be approved. In private industry, the decision-making process is often less stringent. Smaller companies have fewer human resources and lower project volume, so there’s less tendency to create and enforce a structured capital investment program.

For those finance departments feeling the need to move past “gut-feel” estimates and closer to solid analysis, here’s a how-to primer:

Getting started

Figuring out the fundamental value of an investment can be difficult. One way to reduce some of the guesswork is to implement a capital budgeting process, the purpose of which is to choose the best way to allocate capital in order to maximize the value of the firm, and to make intelligent decisions among alternative investments.

There are three components to a capital investment calculation, all of which involve some level of “guesstimation:” the amount of the initial investment, the amount of the periodic cash inflows, and the timing of cash inflows. Measurement methods for those factors include:

Payback Period: Measured in terms of time, it tells you how long it would take to recover an investment from the returns attributable to that investment.

Net Present Value (NPV):Measured in dollars, it tells you the value today of the inflows and outflows on the project. The cash flows are discounted back, using an appropriate cost of capital that represents what the firm pays for financing, plus a risk factor for the individual project. A positive NPV represents cash generated above and beyond that hurdle rate.

Internal Rate of Return (IRR): Related to NPV, it is expressed as a percentage and represents the rate that sets the cash inflows equal to the cash outflows.

Profitability Ratio: This is the NPV in gross dollars divided by the initial investment. Like a multiplier, it tells you how much money you’ve gotten back per dollar of invested capital. If the ratio is less than one, your project is not returning as much as you put in.

Compare and contrast

While NPV and IRR are the most precise, and preferred by many over the less rigorous Payback Period method, the measures are only as good as the assumptions that go into them.

In addition to the three cash-flow assumptions described above, there is a significant assumption involving how the cash inflows are invested once received; that is, during the life of the project. IRR and DCF both assume that cash generated is reinvested at the project rate of return. “This is the most overlooked assumption in any capital investment scenario,” says Tom Zeller, Ph.D/CPA, professor of accounting at the Loyola University Chicago School of Business Administration and a Center for Corporate Financial Leadership (CCFL) instructor. “Very few people think about the implicit assumption within the IRR or NPV model.”

Nevertheless, NPV, IRR and the rest are powerful tools when understood and used correctly. To help decide which method to use, and when to use it, take a look at this decision tree:

Step 1: Does the project offer an acceptable payback period? Consider things like whether the life of the project is so far out that estimates are unsound; whether the market will change dramatically before the project can pay back its costs; and whether you should eliminate all projects with unacceptable timeframes.

Step 2: Does the project generate NPV given the company’s cost of capital? Consider whether the cost of capital includes a risk premium. Also ask if the cost of capital based on total capital or marginal capital is needed only for this project. Eliminate all projects that do not meet pre-established NPV thresholds.

Step 3: Rank according to NPV and IRR, then standardize according to size using the profitability ratio. Eliminate this step if you have critical strategic goals that should be considered first. You’ll be in a good position to tie the numbers to more strategic factors.

But the numbers can only get you so far, and from here, things become a little bit murky.

More than just a number

When it comes to selecting which improvement is the best investment, Zeller advises managers to use common measures like NPV or IRR to make first and second cuts, which will boost confidence in the projects that remain. But after that, he says, managers should focus more on strategy than on hard-and-fast returns. “At the point of choosing between several projects with positive NPV, it’s a strategic decision. All projects with positive NPV will generate return greater than the cost of capital.”

So qualitative factors such as how well the project supports the marketing strategy, competitive positioning or long-term company operations are much more important than choosing a project with a 16-percent return over one with a 15-percent return.

“At this point in the decision-making process, the key for a financial manager is to be able to think strategically with the numbers,” says Zeller. “A professional has to link the tangible with the intangible. It used to be enough to calculate the NPV or IRR and figure out the best use of capital. Not anymore.”

For example, many companies that install an ERP system are aware of the benefits that exist beyond the cost savings. But they may not realize the intangible benefits. A lot of work goes into this. For instance, the company should be able to articulate how the additional information will be used to support specific strategies, or how changes to the customer order-processing workflow will increase the ability to cross-sell new products or services.

Moving past “gut-feel” analysis to quantitative measures is just the first step. And although a financial manager may again rely on gut instincts in the future, hopefully it will be after extensive analysis and a disciplined attempt to dig into non-financial factors.

Reprinted courtesy of INSIGHT Magazine - "Corporate Financial Leadership Special Issue” (www.insight-mag.com), for the Center for Corporate Financial Leadership (www.ccflinfo.org).