Investment Appraisal – rational calculation or psychological crutch

The only way to tell if a decision was worthwhile is with the benefit of hindsight. However in business, although there are some instances where one can rely on another’s experience, there are many in which there exists no useful precedence to the case. This is where capital investment decisions are critically important to the future running of a business. A bad choice of investment can damage a company’s financial performance over the coming years, whereas a good decision can guarantee profits for a given period.

Looking at the work of Dewing, a contributor to corporate finance writing until the late 1950’s; one can see that there are some valid arguments for the lack of a rational calculation in capital expenditure. Dewing claims that there are 4 main motives as to why business enterprises seek to expand. The desire by the entrepreneurs to value themselves in terms of their setting, i. e. the bigger the business the bigger the man metaphor. This motive is particularly relevant to people who want to succeed in business.

If a man has a field of interest outside his domain of work he may be content running a successful convenience store, however should that man seek to succeed in business he may only be satisfied by running a chain of successful convenience stores. Man’s creative impulse is cited as another possible motive. The desire to see ideas materialise can be a powerful one. One other obvious motive that is never truly neglected is that of economics. Generally a business will seek to expand in order maximise profits and cut fixed costs in relation to production.

These characteristics are a common goal of any business seeking to succeed in its market and maintain longevity. The fourth and final motive put forward by Dewing is Man’s satisfaction in speculation, and especially if this speculation pays dividends. A simple reason behind this is that people enjoy playing games that they think they can play well. Although Dewing’s work can be seen as outdated it does raise some valid points. In regard to today’s environment such motives are likely to be more relevant to individual entrepreneurs and other small-scale enterprises, where individuals make capital investment decisions.

Large corporations with a board of directors are unlikely to be influenced by such motives to such an extent that they rule the collective decision of the board. When expanding, corporate entities will be far more concerned with strategic issues than as to whether the business is going to successfully preserve their image in years to come. Psychological influences in capital expenditure can be seen as only relevant for certain types of expenditure. Those involving expansion of a business and those involving a new business enterprise can become highly subjective decisions.

Decisions such as whether or not to produce a certain product line or grant a customer a loan can be conducted entirely using rational calculations alone. This is the formal financial process in which for the large part there is little room for subjectivity. There are however a few capital expenditure projects that are not evaluated in this way. When there are mathematical methods of investment appraisal it is important to understand them and how they effect the final decision.

These methods can be used in the information-acquisition and selection stages when assessing projects to be undertaken; accounting rate of return, discounted cash flow methods and payback. Discounted cash flow (D. C. F) can be divided into two further categories: Net present value (N. P. V) and internal rate of return (I. R. R). N. P. V takes into account the time value of money and shows what the investment yields in terms of today’s value of money. Usually against the cost of capital i. e. how much funds could be gained elsewhere in a relatively risk free investment.

A high N. P. V is good and is commonly seen as the most important consideration. Example Drury (1996,391) can best describe internal rate of return, “. it is the discount rate that will cause the net present value of an investment to be zero. Alternatively, the internal rate of return can be describe as the maximum cost of capital that can be applied to finance a project without causing harm to the shareholders. ” I. R. R also takes into account the time value of money. It shows how big a safety net there is available for the projects, a high I. R. R will give the shareholders added security of investment in the company.