The Capital Investment Decision-Making Process - Essay Example

The keys stages in the capital investment decision-making process, and the role of investment appraisal in this process Introduction The lifecycle of an investment can be considered as comprising of certain phases. The key stages involved in the capital investment decision-making entail identifying investment opportunities, screening investment proposals, analysis and evaluating investment proposals, approving investment proposals, and implementing monitoring and reviewing investments (Gotze, Northcott, and Schuster 2008, p.6). A. Identifying Investment Opportunities Once the capital investment strategy and budgetary processes are developed, the remaining process hinges on the generation of good investment ideas. Projects do not exist merely to be discerned, rather opportunities for investment need to be highlighted or created, and subsequently exploited (Northcott 2002, p.4). Initial investigation of the proposal pursues highlighting the projects’ feasibility (both technically and commercially). The origination of the proposal can come either from laid mechanisms that the entity has established to scan the environment for investment opportunities; technological developments/changes; or from those working in technical positions (Rohrich 2007, p.3). Investment opportunities or proposals could emanate from analysis of strategic choices, an investigation of the present business environment, research and development, or legal requirements. A two-stage decision approach can be an effective way of encouraging investment ideas whereby, first, organizational personnel are encouraged to advance any preliminary undeveloped ideas that they have. The advanced ideas are then reviewed in the first stage and those that fail feasibility test screened out using decision criteria (Baker and Powell 2005, p.191). The most promising ideas continue to the next stage whereby thorough financial and strategic appraisals are undertaken. The core requisite in this stage details that investment proposal should reinforce the attainment of organizational objectives (Gotze, Northcott, and Schuster 2008, p.8). It is essential to appreciate that even projects that fail to come to realization may produce ideas and information that benefit future investments; hence, unsuccessful projects are not merely a waste of time and effort. B. Screening Investment Proposals An investment idea cannot be evaluated until the idea has been suitably defined and presented. In reality, within the business world, capital markets are imperfect, manifested by the fact that, among other aspects, companies are usually restricted in the amount of finance available for capital investment. Companies, thus, need to decide between competing investment proposals and pick those manifesting the best strategic fit and the most suitable utilization of economic resources. The company’s capital investment procedures manual should outline the requirements for project information, as well as the format of the proposal. The preferred terminology ought to be specified and defined, and the project appraisal methods and criteria should be made clear. Standardized proposal forms should allow for flexibility in the life span, costs, and benefits of projects. However, too much flexibility may constrain the comparability of proposals. Thus, a balance has to be struck to match the organization and the forms of projects it considers (Rohrich 2007, p.4). The screening of the projects may spotlight aspects such as cash flow analysis, critical variables, documentation, and sensitivity analysis. C. Analysis and Evaluation of Investment Proposals Candidate investment proposals require an in depth analysis and appraisal to establish projects, which avail the most attractive opportunities critical to attainment of organizational goals such as enhancing shareholder wealth. Analysis and acceptance stage involve undertaking financial analysis of the project and comparing the project to predetermined acceptance criteria, as well as considering the project as per the capital budget for both present and future operating periods (Baker and Powell 2005, p.192). This is the stage in which investment appraisal plays a critical role, signifying which investment proposals bear the highest net present value. The analysis stage of the decision-making process does not necessarily begin and end with financial analysis, but must also involve other activities. These activities include reviewing the company’s capital investment strategy, and how the project fit with it; highlighting any constraints for investment in the present period; ranking projects as per order of desirability; choosing a portfolio of the best projects that can be paid for, and making a final selection for those projects that can be funded. For projects that have not been selected, it is essential to check whether the projects may have unacceptable negative effects flowing from rejection of the projects and whether the projects can be delayed instead of being rejected (Rohrich 2007, p.4). D. Approving Investment Proposals The authorization of projects should be undertaken based on detailed evaluation and endorsed by senior management. The most appropriate investment is handed over to the relevant level of authority for both consideration and endorsement. Considerably large proposals may necessitate the endorsement by top management such as the board of directors while smaller proposals may be granted at a lower hierarchy such as a divisional level. E. Implementing, Monitoring, and Reviewing Investments In most cases, the best capital investment decisions may be deemed ineffective if the project implementation remains poorly managed and executed. Examples of tasks to be undertaken in this stage include reviewing engineering specification, settling the contract price for equipment or construction requirements, overseeing the development, commissioning, and installation of the project (Baker and Powell 2005, p.192). Project implementation needs the setting up of effective information systems that can avail feedback on progress, results, and critical variables highlighted within the project proposal. Following the implementation of the proposal, the investment project ought to be monitored to guarantee that the anticipated results are being attained and the performance is as anticipated. The whole of the investment decision-making should as well be reviewed so as to assist in the organizational learning and betterment of future investment decisions. It is critical, at this phase, to design any subsequent post audit of a project that highlights the key variables that the review will focus on, the responsibility in availing project information, and the timing of the audit. F. Project Monitoring and Post Audit Project monitoring and post audit avail information critical for the “feedback loop” within the capital investment decision-making process. In some instances, this feedback can aid to identify projects that may be deviating from expectations and subsequently guarantee rectification of the problems and poor financial outcomes avoided (Northcott 2002, p.3). The review process consists of two key stages. First, there is project monitoring, which entails identifying a need for intervention within the present project as it is undertaken while the project is within its early stages of implementation (Baker and Powell 2005, p.193). Project monitoring should highlight a combination of physical measures, as well as financial measures. The second stage arises once the project is fully established and operational in order for the actual outcomes of the project to be assessed. Layout of the Key Stages in the Capital Investment Decision-making Process Source: Gotze, Northcott, and Schuster (2008) A B C D E F G A D F Role of Investment Appraisal in the Capital Investment Decision-making Process Capital investment appraisal avails a framework in which capital projects can be effectively considered, screened, and evaluated. Although investment appraisal methods cannot replace managerial judgement, they aid in making managerial judgements sounder. Investment appraisal is essential because capital expenditure mainly involves investment of a considerable amount of funds and the funds are frequently tied up for many years (Northcott 2002, p.9). When undertaking investment appraisal, it is essential not to overlook non-financial based factors, which may impact on the entire project such as legal issues, ethical issues, political issues, and changes to regulation, quality implication, and level of competition. Proper appraisal of investment projects is critical since a considerable amount of resources of the business will be involved, besides capital investment decisions may be difficult to reverse. Conclusion Capital investments decisions should not be made on an ad hoc basis, but rather should connect into the organization’s existing and planned investment programme. The instituted invested programme ought to be propelled by the organization’s long-term strategy. Investment decisions should align with the strategic and tactical decisions of the organization. The adopted strategy will dictate the products, markets, and technologies that the organization desires to invest in, which means that proposals to invest in projects outside such guidelines are improbable to attain support and commitment or to be approved for funding. References List Baker, K. & Powell, G. (2005). Understanding financial management: A practical guide, Oxford, Blackwell Publishing. pp. 191-193. Gotze, U., Northcott, D. & Schuster, P. (2008). Investment appraisal: Methods and models, Berlin, Springer-Verlag Berlin Heidelberg. pp.3-20. Northcott, D. (2002). Capital invest decision making, London, Thomson Learning. pp.1-12. Rohrich, M. (2007). Fundamentals of investment appraisal: an illustration based on a case study, Munich, Oldenbourg Wissenschaftsverlag. pp.3-8. Read More