a) Senchi Ltd is evaluating an investment proposal to manufacture River boat, which has performed well in test marketing trials conducted recently by the company’s research and development division.
Required:
Identify and explain the stages in the capital investment decision-making process. (10 marks)
View Solution
The key stages in the capital investment decision-making process are identifying investment opportunities, screening investment proposals, analyzing and evaluating investment proposals, approving investment proposals, and implementing, monitoring and reviewing investments.
Identifying investment opportunities
Investment opportunities or proposals could arise from analysis of strategic choices, analysis of the business environment, research and development, or legal requirements. The key requirement is that investment proposals should support the achievement of organizational objectives.
Screening investment proposals
In the real world, capital markets are imperfect, so it is usual for companies to be restricted in the amount of finance available for capital investment. Companies therefore need to choose between competing investment proposals and select those with the best strategic fit and the most appropriate use of economic resources.
Analysing and evaluating investment proposals
Candidate investment proposals need to be analyzed in depth and evaluated to determine which offer the most attractive opportunities to achieve organizational objectives, for example to increase shareholder wealth. This is the stage where investment appraisal plays a key role, indicating for example which investment proposals have the highest net present value.
Approving investment proposals
The most suitable investment proposals are passed to the relevant level of authority for consideration and approval. Very large proposals may require approval by the board of directors, while smaller proposals may be approved at divisional level, and so on. Once approval has been given, implementation can begin.
Implementing, monitoring and reviewing investments
The time required to implement the investment proposal or project will depend on its size and complexity, and is likely to be several months. Following implementation, the investment project must be monitored to ensure that the expected results are being achieved and the performance is as expected. The whole of the investment decision-making process should also be reviewed in order to facilitate organizational learning and to improve future investment decisions.
(5 points well explained @ 2.5 marks=10 marks)
b) The main reason why discounted cash flow methods of investment appraisal are considered theoretically superior is that they take into account of the time value of money.
Required:
Explain THREE (3) elements that determine the time value of money and why it is important to take them into consideration when appraising investment projects. (6 marks)
View Solution
The time value of money relates to the return required by investors and has three main elements:
Delayed Consumption
There is an opportunity cost involved with the investment of funds. Generally, the value of GH¢1.00 now is greater than the value of GH¢1.00 in one year’s time since investors have to give up present consumption. An investor will give up present consumption for the potential of higher future consumption i.e. they need to be rewarded for giving up certain current consumption for certain future consumption.
Inflation
If there is inflation, then investors also need to be compensated for the loss in purchasing power as well as for time.
Risk
The promise of money in the future carries with it an element of risk. The payout may not take place or the amount may be less than expected. An investor therefore needs to be compensated for time, inflation and also risk.
The objective of investment within a company is to create value for its owners. Investors have alternative uses for their funds and therefore have an opportunity cost if money is invested in a corporate project. Investments therefore must generate enough cash for all investors to receive their required returns.
(3 well explained points @ 2 marks each = 6 marks)