Investments can be considered from different points of view. According to the cash flow oriented perspective an investment project can be characterised by a stream of cash flows starting with an initial investment outlay - a cash outflow. The basic task for investment decision-making then will be to ascertain whether the future benefits from the investment will make the initial outlay worthwhile.
An investment project is a series of cash inflows and outflows, typically starting with a cash outflow (the initial investment outlay) followed by cash inflows and/or cash outflows in later periods (years).
This approach on the one hand leads to relatively easy solutions through the use of calculations that allow the stream of cash flows to be converted into (one or more) measures of the investment project's profitability. On the other hand, it limits the analysis of benefits and returns to the effects of cash flows. At this point it is crucial to remember that investment projects often show important effects other than those easily measurable in cash flows (e.g. research and development activities). Nonmonetary effects are considered and described later in Chapter 6.
Other ways of looking at investments exist. Connecting investments to the company's balance sheet (since investments transform capital into assets) emphasises the tying-up of capital. This capital budgeting perspective implies a systematic approach to evaluating an investment as a long-term (or capital) asset. The benefit of an investment project is then seen as the monetary value gained by the company through acquiring a long-term asset in the form of increased future profits and cash flows attributable to that long-term asset.
The cash flow oriented concept that is used throughout most of the chapters of this book has the key advantage that anything that can be measured in cash flow(s) can be transformed and combined into target measures for deciding about a project's profitability. In accordance with the definition used, an investment project requires a long-term perspective and a long-term capital commitment. The investment appraisal methods mainly differ in the way they transform cash flows from different years, the target measure(s) they use as the decision criterion, and the assumptions they make.
Following the same line of argument, a financing alternative can be regarded in a similar way, i.e. it is a project that starts with an inflow typically followed by outflows and/or inflows. This reflects the close connection between investment and financing alternatives and the methods used for appraising each of them.
Investment projects can take many forms. One way to classify them is according to the type of investment. Financial investments can be either speculative or non-speculative and include, for example, shareholder deposits, the purchase of investment certificates and real-estate funds. Investments in assets can be subdivided into those concerning physical assets (e.g. goods, machines, equipment) and those concerning 'intangible' assets (e.g. education, advertising, research and development).
The following figure (adapted from Kern, 1974, p. 14) shows a differentiation of physical investment projects, classifying them according to possible causes for investments:
1. Foundational investment
2. Current investment a) Replacement investment b) Major repair or general overhaul investment
3. Supplementary investment a) Expansion investment b) Change investment (e.g. rationalisation, diversification)
c) Certainty investment
Fig. 1-1: Classification of investments
The distinction between foundational, current and supplementary investments refers to the different phases of products or companies. Foundational investments are linked with a start-up and they can be either investments in a new company, or in an existing company's new branch at a new location. Current investments are replacement, major repair or general overhaul investments: a simple replacement investment is characterised by the substitution of equipment without a change in its characteristics. Frequently, however, the substitute is an improved, non-identical asset. In this case the substitution might also be viewed as a rationalisation and/or expansion investment, making its classification potentially ambiguous.
Supplementary investments refer to investments in equipment in existing locations and they can be classified as expansion, change, or certainty investments. The first type (expansion) leads to a rise in either the capacity or the potential of a company. Change investments are characterised by the modification of certain features of the company for varying reasons. Within this category, rationalisation investments are primarily driven by a requirement to reduce costs (e.g. caused by changed volumes of sales of existing products), while diversification investments arise from the need to prepare for changing production programmes. The demarcation between expansion and change investments can be problematical, since an increase in capacity is often accompanied by a change in the company's characteristic features.
Finally, certainty investments are those that aim to reduce risk in a wider sense. Examples might include buying shares in suppliers of raw material or in research and development companies.
Another possible classification criterion is the operational area that drives the investment. For example, investments can be categorised as being for procurement, production, sales, administration, or research and development. This can be a helpful classification when investment projects are isolated within one operational area and have little or no impact on other areas. However, many investments that are instigated by one operational area affect other parts and other decisions of a company, especially in regard to the availability of internal financial funds.
To illustrate, consider investments in a production plant. The procurement of these long-term assets is primarily decided based upon assumptions about future production. However, an expansion investment carried out to manufacture a new product type (for example) is an interdependent investment project, requiring considerable co-ordination of decisions from areas like sales, production, financing, human resources and research and development. Since the investment links to the company's environment in many ways, it is not just a production-related decision. In such instances, companies should be regarded as open systems and investment decisions should pay attention to the diverse effects that an investment can have. Sometimes, classifying investment projects by operational area can be counterproductive in this regard.
The final, very important, classification criterion is the level of uncertainty an investment entails. A situation of perfect certainty in regard to the effects of investments rarely exists, since investments generally show long-term future effects. However, uncertainty can vary substantially and it is possible to differentiate between relatively certain or uncertain investment projects. For example, a financial investment in fixed-yield bonds can be regarded as entailing little uncertainty. In contrast, investments to manufacture brand-new products usually involve considerable uncertainty in regard to sales potential, market success, and production processes that are not yet well established. Another example is investments in research and development, for which future resource requirements and outcomes (in terms of usable results) are extremely uncertain. For such investments, the necessary forecasting of uncertain cash flows is both difficult and inexact.
Although it is common to categorise investment projects as outlined above (based on cause, operational area, or level of uncertainty), some other project characteristics may be relevant to how they should be appraised. The first of these relates to whether the outcomes of the investment are readily quantifiable. The investment appraisal methods described in Part Two assume that all effects of an investment can be measured in monetary terms (e.g. cash flows or costs and profits)
and attributed to both certain periods and certain projects. But, qualitative differences can exist between competing projects and therefore need to be considered. Projects with substantial qualitative outcomes require different appraisal methods to those with exclusively quantitative/financial outcomes.
Also, time-related differences may exist. A project could involve either a limited or an unlimited time horizon (e.g. for a financial investment), which will affect how it should be appraised. Other differences can result from whether a project is a standalone investment or links into subsequent projects. Investment projects can have no subsequent projects, a limited number, or an unlimited number of subsequent projects. These different forms may affect the profitability of the initial project (they are described in Chapter 5, Section 5.3).
In summary, investments exist in multiple forms: single or multi-purpose; certain or uncertain; isolated or interdependent; with limited or unlimited time horizons; standalone or connected with subsequent projects. All must be considered using appropriate investment appraisal methods. These are applied within a decision-making and control approach that primarily focuses on projects or programmes, i.e. makes decisions about a single investment project or a set of interrelated projects. The decision process usually is called capital budgeting and relates to long-term capital investment programmes and projects that must be assessed by investment appraisal.
Investment projects can be categorised in many different ways. As they have substantially different characteristics, investment projects may require different investment appraisal methods to appropriately assess their impact, value and profitability.
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