Analysis of Investment Projects


Accompanying Files
Study exercises problems
Study exercises answers
Free cash flow calculation

SUMMARY

Managers and investors should consider the following principles in order to analyse investments:

  • cash flows measure the success of a business;
  • never forget to analyze the cash outflows;
  • errors in investment decisions can, and do, prove fatal for many investors;
  • the required return is determined by the risk associated with the assets and liabilities;
  • do not include sunk costs;
  • reduced uncertainty is a key driver of value.  

Shareholders supply funds to a firm for a reason. The reason, generally, is to receive a return on their investments provided to the business. The return is generated by management using the money provided to invest in real assets. That funds are not always invested with the best intentions may be demonstrated by the Lockheed Tri Star program in which the Lockheed firm found itself subject of investigation in Congressional hearings held in 1971 (see HBS case 291-031). As such, management may in a sense be regarded as investment agents since one of their most important decision-making areas lies in choosing between possible investment projects in real assets on behalf of the firm's owners. In practice, management tend to use one or more of these methods to analyze investment opportunities:

  • net present value;
  • payback period;
  • accounting rate of return;
  • internal rate of return.

Of these methods, the net present value is the most conceptually correct. Net present value analysis is a particularly important form of time value of money analysis. A project's net present value equals the sum of its discounted cash flows over a specific time period. Projects with positive net present values create economic profits, and equivalently, these projects provide future cash flows that more than sufficient to cover the investor's opportunity cost. The internal rate of return will in most cases yield similar results, but unfortunately it may also be problematical in some circumstances. 

LEARNING OUTCOMES

At the end of this workshop participants should be able to demonstrate an understanding of discounted cash flow techniques in analyzing major investment decisions, based on the concepts of time value of money and the opportunity cost of capital. More specifically, participants should be able to:

  • calculate net present value and internal rate of return;
  • identify and apply relevant and incremental cash flows in net present value calculations;
  • recognize and deal with sunk costs;
  • describe and explain the advantages and disadvantages of net present value, payback, accounting and internal rate of return techniques;
  • explain the consequences when investment analysis is carried out in an environment of capital rationing, taxation and inflation.

 



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