Strategic Investment Decisions - Essay Example

?STRATEGIC INVESTMENT DECISIONS INTRODUCTION Primary objective of the firm is to maximize value of the firm or more defined to would be enlightened value maximization as titled in the research of Jensen (2001). Enlightened value maximization is aimed not only to benefit the shareholders that claim only financial benefit but also to maximize value for entire stakeholders of internal and external domain. To achieve this enlightened objective managers of the firms are required to make more considered decisions. Among many avenues of challenging decision making capital investment decisions also require extensive evaluation. Capital budgeting techniques are employed to make assessed investment decisions with quantitative results providing justification for the selection of certain opportunity among available options. Though these techniques have successfully gained popularity as deciding tool, however, influence from the human element on decision making still maintains its dominance (paper). Managers of the firm themselves receive impact from their traits leading to influenced preferences in making decision. Among many reasons that advocate the acceptance of human element weight in investment decision, it is also for the fact that capital budgeting techniques has some unanswered queries. For instance, subjectivity of the discount rate used to discount the cash flows. It further states that the outcome of decisions based on capital budgeting techniques does not facilitate learning function as each situation is considered different. Successes or failure of decision from the usage of these techniques are also attributed to manager; and it is a manager who receives promotion (demotion) on success (failure) of project and not the techniques. Also these techniques are not easy to employee and are considered as complex procedures. Hence, mentioned ones and many other reasons lead to advocacy to systematically include human element factor in decision making criteria (Simon (1955, 1959), Margolis (1958), and Cyert and March (1963). This report provides the critical evaluation of capital budgeting technique with application on hypothetical project of construction and discusses the impact of various factors mainly managerial implication in results. In the second part, human impact of managerial attitude towards risk is discussed in detail. THE ALTERNATIVE ‘OBJECTIVE PROCESSES’ EVALUATION The alternative objective processes evaluation has been conducted with developing hypothetical example from construction sector. Example is a construction project of three storey building. Project has an initial cost of UK ?. 75, 192 and has been financed by 60% debt and 40% equity. Table 1 provides cash flow details with application of capital budgeting techniques. Details of estimated initial cost, revenues, expenses, and loan are provided in appendix. Result of each technique application is discussed under heading titled to technique. TABLE 1: Cash Flow     No. Of Years 0 1 2 3 4 5 Working Capital ? 7,049 ? 7,593 ? 8,181 ? 8,814 ? 9,497 ? - Change in working -? 7,049 -? 545 -? 587 -? 633 -? 683 ? 9,497 Initial investment -? 75,193           Cash flow from Investing -? 75,193 ? 7,049 ? 7,593 ? 8,181 ? 8,814 ? 9,497               Revenues ? - ? 64,721 ? 69,879 ? 75,449 ? 81,464 ? 87,959 Less: Total Expenses ? - ? 35,283 ? 37,609 ? 41,305 ? 44,888 ? 49,372 Cash From Operating ? - ? 29,438 ? 32,270 ? 34,144 ? 36,576 ? 38,587               Cash Flow -? 75,193 ? 36,487 ? 39,864 ? 42,325 ? 45,390 ? 48,084 Interest Expense   ? 1,805 ? 1,471 ? 1,125 ? 765 ? 390 EBT   ? 34,682 ? 38,392 ? 41,200 ? 44,626 ? 47,694 Tax(0) ? - ? - ? - ? - ? - ? -               Total Cash Flows(after Tax) -? 75,193 ? 34,682 ? 38,392 ? 41,200 ? 44,626 ? 47,694 R   ? 0.05 ? 0.05 ? 0.05 ? 0.05 ? 0.05 DCF -? 75,193 ? 33,031 ? 34,823 ? 35,590 ? 36,714 ? 37,370 PAYBACK PERIOD   -? 42,162 -? 7,339 ? 28,251     Based on the positive NPV, the project is suggested to be feasible to undertake. Moreover, evaluation of NPV and other techniques is as follows: 1- Net Present Value and Discounted Cash flows : NPV of the project provides net of present value of projected future cash flows and the cost incurred for a particular investment. Positive NPV suggests the project is feasible for investment purpose. NPV of this project is UK ?. 97,461.52. Among the large number of benefits that NPV has, it has certain limitations as well. Most prominent to state is the level of complexity that does not allow layman to understand it. NPV does not provide the answer to many questions regarding economic attractiveness of investments. Discounted cash flows being the component of the NPV has to face criticism as NPV. Criticisms remain mainly for the benchmarks for estimating future cash flows and if all the risks other than cost of capital have been accounted in the discount rate (Davis, 2002). Future cash flows are subject to uncertainty than initial outlay estimation. To account risks associated with NPV, Ye, and Tiong, (2000) suggest dynamic model of the net-present-value-at-risk (NPV-at-risk) method for evaluation. NPV valuation is also considered to be biased with manager attitude. For instance, over confidence of manager can influence the estimations. Overconfident managers are likely to overestimate positive (negative) information and affect the estimation, hence, decisions. Similarly, over (under) pressured discount rate either is extremely high than company’s cost and associated risk or vice versa; resulting manager specific decision with intention to extract high returns from investments (Shleifer, and Vishny, 1989). NPV of this project has been developed with limited information available to the manager. Therefore, it is also posed with the risk of not incorporating the effect all risks and information in cash flow and discount rate. 2- Pay Back Period The Payback period refers to the time project takes to return or payback the initial investment incurred for that particular project (Gitman, 2003). Project that is able to generate back the initial investment in the desired time frame is considered eligible for acceptance under this rule. Payback period for this project is 2.79 years. Payback period method has been criticized as being flawed for ignoring the present value of future cash flow that firm is expected to generate once initial investment in recovered. Also payback period if measured using accounting cash flows ignores the impact of timing; while on the other hand, calculating payback period using discounted cash flows carries with it impact from criticisms that are posed to discounted cash flows. Payback period is also influenced from the preferences of the managers in decision making. Once the project is initiated and overtime found to be unsuccessful based on Payback period even then it cannot be winded up and leading to managers sticking to such less profitable venture for longer time (Paper). Unsuccessful project with respect to Payback period brings dual loss to the firm; first, from failure to not being completed in projected time and the opportunity cost for the consumed years. In discussed case, the timeframe is set for 5 years and project is completed within 3 years. In case any discrepancy caused project Payback period to be delayed far beyond the 5 years, then the project cannot be undone after spending considerable time and cost. 3- Internal Rate of Return Internal Rate of Return (IRR) calculates the rate of return from a project at which cash inflow and outflow equates. IRR can also be defined as the point where the NPV of the project is 0 (McLaney, 2009). IRR is compared with discount factor or a hurdle rate and project with IRR greater than discount factor or hurdle rate is accepted. IRR of this project is 37% which is far above the discount rate. It provides an important measure to make selection among available opportunities. Project that has the highest IRR is the one selected for investment purpose. IRR as valuation technique also has certain problems in ranking among available options, selection of mutually exclusive options, timing options, sometimes conflict with results of NPV etc. Since IRR is also calculated from the discounted cash flows, influence of manager’s bias would also affect this measure. Risk from external environment or risk that cannot be accounted or influences from managerial bias attitude would have equal impact on resulting IRR as on other measures. 4- ARR (Accounting Rate of Return): Accounting rate of return is the return that project is able to generate over a period understudy. The accounting rate of return for the project is 55 percent. The biggest disadvantage with this technique is that the technique does not consider time at which the cash is received. Usage of accounting rate of return to infer economic significance of project is constantly under debate. IRR or economic rate of return accounts provides return from discounted cash flows is considered to be providing more relevant economic significance whereas ARR is based on the systematic designed information available in financial statements (Feenstra, and Wang, 2000). Elmendorf (1993) has maintained criticism that ARR cannot be considered equivalent to ERR or IRR and consider this measure as biased estimate. Hence, to measure the feasibility, IRR is widely accepted as a guiding tool. 5- Adjustment of required rate of return: The required rate of return is usually adjusted for various risk factors specifically inflation factor. For this project, ARR of 55 percent has been adjusted for various risks such as inflation and other changes by 5 percent due to increased volatility in the economic conditions of firm. This way the risk adjusted return of the project is safer measure and assess if the project still remains feasible after adjusting for risk. Risk analysis is growingly made part of the decision making due to rapid increase in dynamics of economic conditions. Manager to ensure that project is able to maximize the value of the firm ensures projected return is well adjusted for various risk (Arnold, and Hatzopoulos, 2000). Oswald, and Jahera, 1991) study suggests that risk adjusted performance is also affected by levels of ownership; hence, depending upon the stake manager can impact this decision. However, there is no measure to calculate how much risk shall be adjusted and it is used as combination of various measures, therefore manager discretion based can influence the return presenting project. 6- Sensitivity analysis: Sensitivity analysis is a technique that analyses changes in results due to change in any particular variable. As the name implies sensitivity analysis provides information regarding the element to which project understudy is the most sensitive. For instance, if this construction of building is aimed to be rented to students then education and immigration policy variables will add to risk factor and is likely to have most dominant impact etc. For this project, sensitivity analysis for two variables i.e. total revenues and total cost has been conducted with each variable accounting for optimistic and pessimistic analysis and impact on NPV has been viewed as given below: Scenario Summary         Current Values: Change in Rentals A Change in Rentals - B Changing Cells:         RENTALS 64080 74000 55000 Result Cells:         NPV ? 92,898.37 ? 101,896.10 ? 84,662.54 Scenario Summary         Current Values: Change in Exp- A Change in Exp- B Changing Cells:       Expenses   ? 35,052.81 ?45,000.00 ? 25,000.00 Result Cells:       NPV   ? 94,763.79 ? 85,741.40 ? 99,346.84 The summaries provided above details that project’s NPV is comparatively more sensitive to change in rentals than changes in expense. However, the impact has been studied on entire portion than more relevant in-depth analysis of components of these variables. Sensitivity analysis, though, assess changing results with change in variable, but being limited to exploration of impact of certain variables that may have interrelated impact with other variable is debatable. Managers with biased attitude can use this technique to influence the decision of investment. To get investment decision diverted to certain direction, manager can present the desired result with over-weighted impact from certain variable (paper). BEHAVIOURAL / PEOPLE ASPECTS OF CAPITAL INVESTMENT DECISION MAKING There are different capital budgeting techniques and project appraisal techniques that have been used by the management to evaluate and analyse project feasibility. People belong from different cultural background, ethnic background, have different values and norms, have different perception and beliefs and all these things influence how people think and make decisions. Although, investors and management use different techniques to evaluate and analyse the feasibility of the project, and some of these techniques might give opposing results and therefore it is up to the management or the investor to make the decision to select which technique. Some investor would prefer using Accounting Rate of Return whereas others would use Net present value to make the investment decisions. It is because of the reason that whenever investors are making decisions their behavior and their emotions come in the way that influences the decision. Behavior finance is the study to analyse and understand how people take actions and analyse the financial information they have (Simon, 1987). Impact from manager’s behavior on investment decision resulting from psychological factors has been well traced since long back. It is noteworthy to mention, this impact has been so accepted by researcher that they conclude to make these driving motives and biases part of systematic procedure of investment decision. Gervais (2007) also advocates to add human element part in the decision making process as the behavior and emotions also influence the decisions made by people. Among motives and biases that drive investment decision in a particular way is the managerial attitude towards risk. It is the objective of the management or the investor to maximize the profits of the investment. However as emotions influence the decision of the managers and therefore their objective of achieving the maximum profits is influenced and therefore their decision making does not remain rational (Elan, 2010). Emotions of the managers or the decision maker influence the expected profits of the project and therefore they are not able to achieve their desired results. Richard Thaler is a professor of Behavioural Science and Economics has claimed that investors and managers make financial investment decision however these financial decisions are influenced by how these investors interpret and understand the available information (TIAA CERF, 2007). This also influences the decision making ability of the investors or the managers and therefore the optimum level of profits is not achieved. At times, the managers are too much focusing on minimizing the risk of the project and they are not able to achieve their main objective of profit maximization. Instead, their main focus becomes reduction of risk rather than maximization of profits. With perspective to taking risk, managers are broadly categorized as risk averse (with low tolerance for risk) and risk takers (with high tolerance for risk). Manager’s attitude towards risks is reflected in various instances, such cash flow estimation, discount rate and hurdle rate estimation, estimates of firm’s earning, completion of project etc. Though it is not mandatory that same behavior is reflected in all decisions, however, being the behavioral trait it is likely to remain more or less same. Managers are responsible for their actions and decisions they make, therefore generally managers try to analyse the situation and project from different perspective. Management analyses the risk they are facing from all possible angles and this changes their attitude from achieving the maximum profits on the investment to minimization of risk. In order to reduce the risk of the project, managers take defensive decisions or decisions that could have increase the profits drastically but only to mitigate the risk of that particular decision, managers to not make that decision as they are aiming to reduce costs rather than maximize profits. Capital budgeting technique evaluation section discussed in detail the impact of manager’s influence on techniques to divert decision. For instance, risk-averse manager would try to increase the discount rate and be conservative in cash flow estimation etc. Moreover, decision of manager with such trait would be biased based on more pessimistic sensitivity or scenario analysis. On the other side, if the manager is aggressive in risk taking and is driven with high level of confidence or sometimes over confidence, then results would be otherwise. This risk aggressiveness gets more prominent with over confidence level where managers start to over value their skills (Gervais et al., 2009). Also risk aggressiveness results from the manager’s over confidence level where they start believing that factor are more under their control than their actual status March and Shapira’s (1987) results of such belief are reflected in increased commitments to projects where other rationally behaving managers would be less committed (Van den Steen, 2004). Risk aggressive managers are also prone to be more prone toward strategic alliances mergers and takeovers. This high degree of risk taking supported by over confidence often leads to loss to the firms. For instance, Moeller, Schlingemann, and Stulz (2005) studied series of acquisition and noted the losses the acquiring firm made. This loss is due to risk aggressiveness combined with over confidence leading to over bidding of the acquisition targets Malmendier and Tate (2008). Simon and Houghton (2003) develops that such managers are also very aggressive in entering in new markets which may also result in failures. It is noteworthy to mention that risk aggressiveness appear to play active role once manager succeed with extra mile risk and develops habit; often resulting in over confidence. Also this aggressive attitude towards risk is more visible in small firm and private firms where managers do not answer to board of management and less people involved leads to less detailed process (Busenitz, and Barney, 1997). Manager with counter trait of being risk averse, on other hand, demonstrates increased cautious behavior in every discussed situation. To control this extremely positive or negative behavior attitude’s impact on the decision making; firms develop certain barriers to balance the impact. For instance, hurdle rate serve as trimming factor for such aggressive attitude Dobbs (2009). Also contractual incentive are bound for managers so that risks are only taken in the best interest of firm and not just risk for sake of risk (Gervais et al. (2009). Combining stock options with managers’ compensation is also attempted to control this risk factor. Prospect theory in behavior finance describes how people choose an option when they have different alternatives on hand involving risk. Risk lovers would take the risk and invest in options that might contain some risk whereas risk averse would not invest in the project that has high risk despite of the fact that it would yield double gains. The concept of loss aversion that if people are given option to avoid risk or to maximize profits, then they would go for avoiding risk (Cunningham, 2002). This shows that the decisions made by the managers are influenced by emotions and behvaiours and therefore the attitude of the managers is risk minimization rather than profit maximization. List of References Arnold, G. C. and Hatzopoulos, P. D. (2000). ‘The Theory-Practice Gap in Capital Budgeting: Evidence from the United Kingdom’. Journal of Business Finance & Accounting, vol. 27, no. 603–626. 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