Nato Bebiashvili, Assistant Professor, GTU
Any type of a business is to a certain extent connected with investment activities. Investment decision-making is associated with a whole number of factors that affect the decision-making process, such as the type of investment, cost of investment project, existence of numerous acceptable projects, limited financial resources, risk factor, etc.
Businesses need investments for a variety of reasons that can be grouped into the following three types: renovation of the available material and technical base; increase in production; mastering of new kinds of activity.
It is noteworthy that the level of responsibility for accepting an investment project is different. For example, it is easy to decide on the replacement of existing equipment and facilities with modern ones, for at this time it is clear of what type of equipment and what characteristics the new facilities should have in order to meet the modern requirements. More difficult is the decision-making process when an investment project concerns the extension of primary production activities of the enterprise, because in such a case many new factors are to be taken into account. For example, how such a change would effect the enterprise’s standing on the market, for if the market demand for the enterprise’s product is mistakenly identified, it is quite possible that the new production output will instead of profits yield losses. Due regard should also be given to the availability of necessary material, labour and financial resources, etc.
The volume of expected investment is also of importance. For example, in the case of an investment project worth, for example, 100 thousand the responsibility will certainly be lower than in the case of a project worth a million and over. That is why the head of a joint stock company is authorized to independently decide on a relatively small value project, whereas in the case of high-value projects all decisions shall be made by the board of directors.
Since financial resources of any company are limited, any investment decisions need to be optimised. When a decision is to be taken in respect of several alternate or independent project proposals, it is of importance to make a right choice on the basis of the criteria adopted in international practice, although the CEO’s insight and intuition should not be disregarded as well.
The process of making managerial informational decisions is based on the appraisal and comparison of the rate of expected investment and future revenue.
Since the comparable indices belong to various moments of time, the main problem here is their comparability. It can be understood differently, depending upon the existing objective and subjective conditions, such as rate of inflation, level of investment, producible (receivable) incomes, forecasting scope (horizon), analyst’s skill level, etc.
Since such activity is carried out under conditions of uncertainty, the level of which is rather variable, a very important role in investment activity is assigned to the risk factor. An accurate identification of an economic effect is thus very problematic.
Investment decision-making is based on different formal and informal methods. There is no one universal method applicable to any case. Management is probably more art than science, although the appraisals obtained by a formal technique assist the manager in making a final decision.
Any investor strives that the capital invested by him or her would yield maximum profit, or that the investor’s cost outlays would ensure the economically most effective outcomes. The cost outlays in this case imply investments, while the outcomes – the income receivable as a result of the investment project running. The time interval, which is formed from the start of the project running to its end or liquidation, is the project life cycle. As a rule, investment companies have several alternative investment projects. Limited financing appears to be the most limiting factor for implementing such projects. Therefore, it is necessary that the most optimal project be selected from among the alternative versions. Expediency of an investment project is determined based on a comparison of the project implementation costs with the obtained results.
In making this, the following conditions shall be met:
1. The comparable investment outlays and the actual results shall be measured by the same value;
2. The comparable units shall be expressed in the same currency. This can be the national currency of the given country or any freely convertible and relatively stable foreign currency (for example, dollar or euro);
3. When comparing the investment inputs and the actual results under conditions of an unstable economy and against the background of permanent price variability, inflation processes shall be necessarily taken into consideration. Such methods are to be realized in case the national currency’s inflation rate exceeds 5 to 6 percent per year.
4. Any project is implemented during a definite period of time. Since monetary funds at different time intervals tend to be non-equivalent in relation to one other, the time factor must be taken into consideration when comparing the investment inputs and the actual results. This is when discounting is applied.
The world economic practice has worked out different methods of evaluating investment project proposals. Given that they envisage all possible conditions of project implementation, these indices are characterized of universality. Their application allows appraise the efficiency of any project with a particular accuracy. Since all projects differ from one another, these indices proper, which provide for their individual peculiarities, should be employed for each of them. The evaluation of investment project proposals represents a major procedure for making investment decisions. The future of the capital to be invested depends on how accurately, objectively and comprehensively is the evaluation carried out.
The methods used in an analysis of investment activity may be divided into 2 groups:
1) Dynamic or discounting valuation-based methods;
2) Static or accounting valuation-based methods.
To the group of discounting valuation-based indices belong:
o Net Present Value (NPV) method;
o Internal rate of Return (IRR);
o Profitability Index (PI);
o Discounted Payback Period (DPP);
o Modified Internal Rate of Return (MIRR);
To the group of accounting valuation-based indices belong:
o Payback Period (PP) (investment recovery time);
o Accounting Rate of Return (ARR).
In our view, an understanding and application of all above-mentioned methods can be useful for all persons interested in investment projects.
It should be mentioned that the assessment of investment project efficiency takes place taking into consideration the criteria that meet definite principles. Namely, the impact of the value of money; consideration of alternative costs; consideration of a possible alteration of the project parameters; calculations on the basis of actual cash flow rather than on the accounting data; the reflection and consideration of inflation; consideration of the risk associated with the project implementation.
The Payback Period (PP), otherwise known as the investment payback (recovery) period, is found as an expected number of years needed to recover the initially made investments. It was the first static criterion used for evaluating investment project proposals. The simplest way of the payback period determining is a calculation of the accumulated cash and finding of a moment when its equals zero. The economic rationale of this index is that it serves the investor to understand in what period he or she will be able to recover the invested capital.
To our mind, it would be better to use a modification of these criteria – the discounted payback period (DPP), which is calculated by the same algorithm, yet on the basis of the cash flow being discounted by the project capital cost. The project capital cost reflects: 1) total cost of the company capital, and 2) the risk difference between the given project and a project to be evaluated.
This index is found as the number of years needed to recover the investment according to the discounted cash flow (DCF) data:
DPP is calculated by the formula: DPP=min n, when 1
Where Pk is the rate of accumulated cash flow; is the initial investment.
In discounting, the payback period always tends to increase, i.e. DPP>PP.
We note that both criteria represent in themselves a certain version of the “dead point” calculation, under which the moment when the accumulated cash flow becomes positive. The conventional payback period calculation does not envisage a calculation of the cost of own and loan capital, while the discounted payback period characterizes the moment by which all the costs of the own and loan resources attracted to finance the project will be recovered. Both of the criteria have some serious shortcomings though. In particular, they ignore the impact of the cash flow elements that occurs following the payback period. They have also other shortcomings which, however, do not render a material distorting impact on the results of alternative projects and are not therefore discussed in detail here.
Notwithstanding the mentioned shortcomings, these criteria indicate the time for which the financial resources will be frozen in the project. Thus, all other conditions being equal, the shorter the payback period, the more liquid will be the project and less risky at that. The employment of these criteria is also advisable when a company is concerned with the rise of liquidity. Of importance is the use of these methods for calculating investment projects’ financing options. The PP and DPP criteria are useful in calculating projects to be financed by long-term liabilities. In such case, the project payback period shall be shorter than the loan capital use period.
The Accounting Rate of Return (ARR), also known as the profit accounting rate, is based on the net profit rate rather than on the cash flow. It is the static valuation method, the merit of which is in the ease of calculation.
The ARR ignores the time value of money and excludes discounting. Correspondingly, it was used for calculating short-term projects only characterized of uniform revenues (inflows). It should be mentioned that companies use the AAR method to assess performance of their divisions. The application of the ARR criterion for such purposes is fully justified as compared with its use for evaluating investment project proposals.
Given that the ARR and PP criteria have explicit shortcomings, the researchers have always tried to find more effective project evaluation criteria. One of such criteria is deemed to be the Net Present Value (NPV) method that is based on the cash flow discounting methodology.
The NPV calculation algorithm is as follows:
1. The current cost of all cash flow elements discounted by the given project’s capital cost is calculated.
2. The DCF values are summed up to find the NPV of the project.
3. If NPV>0, then the project should be accepted, and if NPV <0, then the project should be rejected. Where two projects are alternative/mutually excluding, then a project with the higher positive NPV should be chosen. The NPV may be expressed as follows2: Here CFt is the expected net cash flow at t period; and k is the project’s periodic cost of capital. The NPV criterion’s logic is fully clear. The zero NPV means that cash flow generated by the project is sufficient for: 1) recovering the capital invested in the project, and 2) ensuring the required payback thereon. If NPV>0, then the cash flow will generate profit and the profit remaining after the repayment of credits at a fixed rate will accumulate directly for the company shareholders. Correspondingly, if the company accepts a zero NPV project, the shareholders’ condition will not change – the scale of production will be enlarged, but the share price will remain unchanged. And, on the contrary, if the company accepts a positive NPV project, then the shareholders’ condition will improve. Both analysts and investors are of an opinion that companies will be looking for the projects with positive NPV, and the current share price will immediately respond to such an activity. Thus, the share price responds to the announcement of a new investment project only if such project had neither been earlier considered nor influenced the price movement. From this standpoint, the capitalized value may be presented as a set of two elements: 1) the market value of the already available assets, and 2) the “growth opportunity” value being presented as the total of NPV for the accepted projects.
The Internal Rate of Return (IRR) is the discount rate which forces the present value of the project’s cash outflows (costs). The project is accepted if the IRR is greater than the project’s cost of capital.
The IRR may be calculated very easily with the help of financial calculators and/or computers. Most companies have computerized the process of capital budget making and the IRR, NPV and PP calculations for purposes of investment projects.
As a matter of fact, the IRR characterizes the expected profitability of a project. If the IRR exceeds the cost of capital used for financing the project, it means that the capital-use calculation will result in a surplus to be allocated among the company shareholders. Correspondingly, the acceptance of a project where the IRR is larger than the cost of capital will increase the shareholders’ wellbeing. On the other hand, if the IRR is less than the capital cost, then the project implementation will be unprofitable for the shareholders. This is exactly what explains the usefulness of the IRR criterion in evaluating investment project proposals. Professor I.A. Blank notes: “In characterizing the internal rate of return, it should be mentioned as the most applicable method for comparative evaluations3”.
The next criterion used for valuating a project is the Profitability Index (PI) or Benefit/Cost ration (income per unit of cost). The PI is the ratio of the present value of cash inflows to the present value of cash outflows. The PI shows the profitability of a project per one dollar of investment.
The PI is a relative ratio of an investment project efficiency indicating the income level per unit of cost. If PI>1, the project shall be accepted, if PI<1, the project is to be rejected; if PI=1, the project will be neither profitable nor unprofitable. In terms of mathematics, the NPV, IRR and PI criteria are interrelated, that is they allow to make an accept/reject decision: if NPV>0, then the IRR >k and its PI>1. Although the NPV, IRR and PI might produce conflicting answers for mutually exclusive investment projects.
In our view, the NPV criterion is in preference to the IRR and PI criteria. Notwithstanding this, the IRR and PI criteria are frequently applied and they are widely entrenched in industry, and they have some unique virtues. Therefore, it is necessary to know the nature of the IRR and PI criteria; to understand and be able to explain why so happens that in some cases a project with a lower IRR and PI may be preferable to one with a higher IRR or PI.
The IRR can be modified into the effectiveness index that will allow correct its significant shortcomings originating upon multiple drain of money. This index, known as the Modified Internal Rate of Return (MIRR), has a significant advantage over the regular IRR. MIRR involves finding the terminal value (TV) of the cash inflows compounded at the firm’s cost of capital and then determining the rate (MIRR) which forces the present value of the TV to equal the present value of the outflows4.
MIRR assumes that cash flows from all projects are reinvested at the cost of capital, while the regular IRR assumes that the cash flows from each project are reinvested at the project’s own IRR. Since, reinvestment at k is generally more correct, the modified IRR is a better indicator of a project’s true profitability. The MIRR also solves the multiple IRR problems. Expediency of introducing the MIRR method is supported by the well-known scientists J. Friedman and N. Ordway5.
We consider that the MIRR is more expedient than the IRR in characterizing the actual profitability of a project; and yet the NPV is still better in analysing alternative projects, for it clearly shows how much an optimal project can increase the company value.
In conclusion, we can said, that the different project valuation criteria provide managers (decision makers) with different types of information. Since a calculation of criteria is not difficult, all of them should be given a due regard in the decision-making process. In each specific case one criterion tends to be weightier than the other; and still ignoring the information contained in each criterion would be a mistake.
In our view, all the above-discussed indices, taken separately, do not provide a sufficient ground to make an accept/reject decision on an investment project. Investment decisions shall be made taking in consideration all the indices, as well as the opinions and views of all the stakeholders.
In our opinion, two parties should be meant in an investment. Both should be interested in the final result. Investor should be able to select an appropriate partner and take into consideration risk factors and a final result – profit. A recipient should create a safe environment and conditions for the minimization of the corruption. The other party is responsible for flourishing this or that field, receiving proper tools and work places which will finally improve the social economic environment of the recipient. Consequently, an optimal variant, when both parties benefit should be accepted.
A significant part in decision-making is given to the structure of the capital being invested, although to calculate all by a mathematical formula is just impossible – a human factor is also of no less significance.
The parameters, accepted in international practice, which were discussed by us above and should be used for selecting investment projects and in decision-making, are less applied in Georgian reality. This causes negative results. Recently making of the investment projects has become closer to the international standards.
In our opinion, introduction of the methods of estimating investment projects’ efficiency will be very important for Georgia.