Fundamentals of Investment Appraisal

An Illustration based on a Case Study

Martina Röhrich

• Publisher: De Gruyter Oldenbourg
• Year: 2014
• Print ISBN: 9783110347180
• eBook ISBN: 9783110397192
• Edition: 2
• Topic: Business
• Subtopic: Finance
• Index: Business

How to make sound investment decisions: Fundamentals of Investment Appraisal, 2nd edition, is based on long-term experience with students and is written in an easily understood style. A case study has been constructed to illustrate all methods discussed.

The goal of the book is to pace a sure way through the variety of methods in investment appraisal. Mathematical basics are specifically explained in detail. The book shows clearly why there are different methods in investment appraisal and on where to focus in a given situation. As all methods are introduced by the same case study, it is easy to compare and evaluate the results.

The statements in the text are further consolidated by abstracts and evaluations of each of the methods. Exercises with extensive solutions will lead to the confidence which is necessary for an ease of handling the investment appraisal techniques and for a good preparation for students' exams.

German and international students at universities and other institutions of higher education will find this book an excellent systematic preparation for their exams.

1 An Introduction to theInvestment Decision

1.1 Learning Objectives

This chapter will provide you with the basics of financial appraisal of investment projects.

• – By means of a fictitious car sharing enterprise we will explain the requirements and the aims of investment appraisal as well as
• – the interaction between investment decisions and business finance.
• – It is necessary to identify different types of investment and
• – to distinguish between the stages of the investment process.
• – Furthermore, a first overview of investment appraisal techniques is provided.
• – Finally, this chapter ends, as all the other chapters will do, with questions and respective solutions.

This book is based on a continuous case study that is introduced in the following section.

1.2 Case: Car Sharing Company

During a break between two classes a group of students have the idea to found a car sharing company. In so doing they aim to supplement their income and moreover to improve their quality of life. In order to help them transact business someone makes a used laptop and a printer at the amount of € 1,000 available to the group of students. Furthermore the students bring in € 20,000 that a bank lends them at a rate of 5 % interest on the merits of their undertaking. In this case study, the selection of the interest rate is expressly not geared to the reality, but is selected so that results can be easily and understandably recalculated.

The most urgent initial task to run the business is the purchase of an appropriate vehicle. Since the students can’t be certain of the success of their business a rather inexpensive vehicle should be bought because it could be resold easily in case of need. After a pre-selection there are two vehicles short-listed: The petrol-driven car HL Securitas¹ of Hermedes Lenz and the electric car BMC Minerva² of the Bremen Motors Corporation.

With the help of the different methods of investment appraisal from Chapter 2 on, we will pursue the question of which vehicle should be purchased. In order to focus attention on areas of major importance we start working with a very simplified model. The real world complexities like uncertainty, taxation or capital scarcity are taken into account. They will be added layer by layer to the model with which we start. However, as a start, we begin with the basics of investment decisions.

1.3 Investment Decisions and Business Finance

Capital expenditure decisions involve a substantial outlay and will bring benefits over a long time horizon. An investment involves the sacrifice of an immediate level of consumption (i.e. a dividend now) in exchange for the expectation of an increase in future consumption (i.e. an enlarged dividend later). To be viable the investment project’s benefit must warrant its initial capital cost and some extra benefit to compensate for the risk involved. Decisions on investment projects have a direct impact on the ability of an organisation to meet its goals. For investment decision making, we usually use as a valuation base the fact whether the investment project benefits the shareholders.

A necessary precondition to undertake an investment is its financing. This means providing the funds to start and sustain the business. The main purpose of business finance is to assure the financial equilibrium to provide the necessary liquidity for the enterprise.³ We are not concerned here with whether the funds that finance the investment project should be provided by financial markets outside the company or whether the funds are generated from the returns of the organisation itself. We assume that the company has adequate financial resources to undertake the investment, so that we can focus on the cash flow of the investment. In Chapter 5 we are going to drop this assumption. There you will learn how to integrate financing flows and how to deal with special features of financing.

1.4 Classification of Investments and Stages of theInvestment Process

With regard to the nature of the asset we can distinguish between the following investments: Physical investment (e. g. real property or machinery), financial investment (e. g. stocks or shares in other companies) or intangible investment (e. g. investment in employee education, investment in advertising campaigns, research and development). On principle, investment appraisals can be made regardless of how the investments are classified.

According to the reason for the investment we distinguish between investments to found or to extend a business and reinvestments (replacement investments or rationalisation investment). In this book, for each method, we first address the problems which arise when comparing alternatives of asset purchase. We then cover the application of investment appraisal techniques to the replacement of an asset, in order to accommodate the different decision situations.

The decision-making process consists of different stages:

1. Planning.
2. Identifying the alternatives to be considered and their transformation into workable proposals.
3. Appraising the alternatives and selecting the best one with regard to the organisation’s goals is the third step. In order to select an investment opportunity and to decide whether the firm is better off or not after implementing the investment, appraisal techniques are used. The basic question is whether the benefits of an investment are worth the outlay. This stage is considered in this book. But this is not yet the end of the decision-making process. After having decided which investment to undertake,
4. Implementing the decision.
5. The final stage entails reviewing the selected investment project.

1.5 Investment Appraisal Techniques

To undertake an investment appraisal exercise several techniques can be used. The role of investment appraisal is to ensure that relevant information is gathered relating to all the alternatives and to enable decisions to be taken with consideration being given to the objectives of the organisation. Whether we take into account that money and, therefore, the input variables of an investment appraisal have a time value or not, we distinguish between

• – non-discounting methods of investment appraisal (Chapter 2) and
• – discounting methods of investment appraisal (Chapter 3).

At this stage it is w...

Table of contents

• Fundamentals of Investment Appraisal
• Title Page
• Copyright Page
• Table of Contents
• Preface to the Second Edition
• Preface to the First Edition
• Abbreviations and Symbols
• 1 An Introduction to theInvestment Decision
• 2 Non-discounting Methods ofInvestment Appraisal
• 3 Discounting Methods ofInvestment Appraisal
• 4 Investment Decision Makingunder Conditions of Uncertainty
• 5 Advanced Topics of Investment Appraisal
• 6 Index of Questions and Solutions
• 7 References
• 8 Mathematical Tables
• 9 Index