ABSTRACT
Overview Strategic investment decisions often are one-off opportunities that have a very wide range of alternative potential outcomes and may depend on a sequence of successful outcomes to earlier stages in the total investment programme. The payback method of evaluation is a good indicator of the risk involved
in an investment opportunity, particularly if expressed as a proportion of the expected economic life of the project. The discounted payback calculation allows for the time value of money by applying a negative interest rate to future cash flows to bring them to their equivalent present values. This is also done in the full discounted cash flow technique, but the discount
factors are applied to all the future cash flows. In the net present value method, a criterion rate of discount is selected and applied to all the cash flows so that a net present value is computed; the higher a positive net present value is, the more financially attractive is the project. If the criterion rate is very close to the shareholders’ required rate of return, the net present value is a very good indicator of the shareholder value creation potential of the investment opportunity. The internal rate of return (IRR) method applies alternative rates of discount
to all the expected cash flows, until one is found that generates a net present value of zero; this discount rate is the project’s IRR. Although it is very popular, the IRR does have several flaws and problems, with the result that the net present value method is to be preferred. The net present value can be turned into a percentage or ratio by dividing it by the value of the original investment; this is called the profitability index. The profitability index can be used to rank possible alternative investments if companies wish to maximise the net present value generated from any finite capital investment budget (a process known as capital rationing). The wide range of potential outcomes and sequenced stages of many strategic
investment decisions mean that the use of probability estimates can be very useful. The probabilities of success of each stage are assessed and these can be used to compute the cumulative probability of the ultimate cash inflows. This process takes account of the specific project risks so that these probability adjusted cash flows can be discounted using the company’s cost of capital.
If the ‘success’-based cash flows are used, a much higher discount rate must be applied to take into account the risks involved in the project. Applying a very high discount rate creates some problems because it can heavily discount some relatively certain cash outflows in the early years of the investment project. Many strategic investment projects can also be viewed as containing options
which can themselves be significantly valuable. These real options have the same value drivers as the more familiar financial options, but the practical application of the sophisticated option valuation models requires sound common sense if the value of any flexibility is to be accurately reflected. The use of real option valuations is particularly relevant in phased, high-risk strategic investments that have very low, or even negative, net present values under normal discounted cash flow techniques. The value of the option can frequently more than outweigh the negative net present value of the underlying cash flows.
