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Links between investment and financial strategy
Investment in assets, plant and equipment or entire companies can be considered as a strategy and, for some, also the sole objective, that is, to grow by acquisition. Presumably there is a clear objective, that being to make an adequate return on the investment - maybe not in the short term but hopefully the long-term objective is return and not simply growth for growth's sake.
From the earliest days there has been waste: destruction of investor and shareholder value through unwise investment. Examples can be found in the latter phase of railway investment at the end of the 19th and beginning of the 20th centuries when lines were built that would never repay the investment, having sedentary lives of less than 50 years before closure and abandonment.
Investment should be focused on making returns, which often do come from expansion and growth but can also arise from efficiency, eg through automation.
Content, order and logic of this chapter
Within this chapter we will cover the following topics:
- The need for investment appraisal
- The time value of money and required rates
- Cash flow models
- Common appraisal measures
- Risk identification and management
- How much analysis should be carried out?
- The need for a consistent and robust process
- The many uses of appraisal models.
Order and logic
There is a clear need for investment appraisal: in simple terms, not to waste money on poorly performing or unnecessary investment. As outlined in the explanation of links between investment appraisal and strategy, lack of clear financial objectives, specifically making an adequate return and then testing to identify if these objectives are likely to be met, is a weakness that has occurred in the past and for which there is no excuse today.
Understanding the arithmetic (it is but arithmetic!) used when considering the time value of money is key to understanding investment that will deliver returns over time.
The arithmetic and time value of money concept then leads to models and common appraisal measures, typically net present value (NPV) and internal rate of return (IRR) of the potential investment's cash flows. Thus a model with reliable cash flows is required. It is often the cash flow model that is flawed both in amounts and in timing; the basis of cash flow data should be clearly evidenced and any assumptions supported. Also, sensitivity analysis and understanding the scale of risk of the constituent cash flows are paramount. All of the stages of investment appraisal need to be approached and carried out within a consistent and robust process.
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