Chap 06

Corporate Finance and Investment
Decisions and Strategies

9th edition
Chapter 6
Investment strategy
and process
Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Learning objectives
This chapter will enable the reader to comprehend the strategic issues in
investment decisions and will give an understanding of the investment process
and related challenges. More specifically, this chapter will:
• Examine the strategic issues in investment decisions.
• Explain the investment process and related challenges.
• Explore how strategy shapes investment decisions.
• Explain issues and challenges in new technology and environmental
projects.
• Explore the investment decision and control process.
• Evaluate the process of post-audit reviews.
STRATEGIC CONSIDERATIONS
• Individual capital projects should be viewed not simply in isolation, but

within the con- text of the overarching business strategy, its goals and
strategic direction. This approach is often termed strategic portfolio
analysis.
Figure 6.1
McKinsey–GE portfolio matrix
Figure 6.1
• The a>ractiveness of the market or industry is indicated by a number of
factors including the size and growth of the market, ease of entry, degree of
competition and industry profitability for each strategic business unit.
• Business strength is indicated by a firm’s market share and its growth rate,
brand loyalty, profitability, and technological and other comparative
advantages.
Figure 6.1
1 Invest in and strengthen businesses operating in relatively attractive markets.
This may mean heavy expenditures on capital equipment, working capital,
research and development, brand development and training.
2 Where the market is somewhat less attractive, and the business is less
competitive, the optimal business strategy is to get the maximum out of
existing resources. The financial strategy is therefore to maximise or maintain
cash flows, while incurring capital expenditures mainly of a replacement
nature. In that case, tight control over costs and management of working
capital leads to higher levels of profitability and cash flow.
3 The remaining businesses have little strategic quality and may, in the longer
term, be run down or divested unless action can be taken to improve their
attractiveness.
Figure 6.2
Typical progression of product over
time
Figure 6.3
Investment strategy
Figure 6.3
Investment strategy
• Businesses offering high growth and the possibility of acquiring market
dominance are the main areas of investment (‘stars’ and ‘question marks’).
• Once such dominance is achieved, the growth rate declines and investment
is necessary only to maintain market share. These ‘cash cows’ become
generators of funds for other growth areas.
• Business areas that have failed to achieve a sizeable share of the market
during their growth phase (‘dogs’) become candidates for divestment and
should be evaluated accordingly. Any cash so generated should be applied
to high-growth sectors.
STRATEGIC CONSIDERATIONS
• Shareholder value analysis (SVA) is a valuable planning tool and guide for
strategic decision-making. It is basically an extension of the NPV approach
where the focus is on business units, strategies and financial goals. A
business is viewed as a portfolio of investment projects, but the emphasis is
placed on maximising the value of strategic business units, not merely that
of the capital projects within them.
• Large-scale infrastructure projects, such as the construction of tunnels,
roads and power stations, are often funded through project finance. Here
the operation is financed and controlled separately from the operations of
the constructor or user.
ADVANCED MANUFACTURING
TECHNOLOGY (AMT) INVESTMENT
AMT example: Foster Engineering Ltd
• Foster Engineering Ltd is considering introducing a flexible manufacturing

system (FMS) to modernise production in a department currently using
conventional metal-working machinery. The declining market and the
awareness that its main competitors have recently introduced new
technology have made the need to modernise plant facilities an urgent
priority.
• An AMT proposal has been put forward, offering an FMS capable of
producing the present output. It involves two machining centres with CNC
lathes, a conveyor system for transferring components and a computer for
scheduling, tooling and overall control. The total investment would cost
£2.4 million, half being incurred at the start and the other half after one
year, at which point the existing machinery could be sold for £50,000. Any
benefit would arise from Year 2 onwards for five years.
• The two quantified benefits are as follows:
1 A reduction in the number of skilled workers from 50 to 15. The annual cost
of a skilled worker is £20,000 (savings of 35 * £20,000 = £700,000 p.a.).
2 Savings in scrap and re-work of £50,000 p.a.
The company requires all projects to offer a positive net present value
discounted at 15 per cent.
• The accountant produces the following evaluation showing that the FMS
proposal has a negative NPV of £159,000 and fails to meet corporate
investment criteria:
• An incensed production engineer in Foster Engineering, on hearing that the

proposal is unacceptable, points to the ‘intangible’ benefits that the FMS
will offer:
• Improved quality leading to a significant, but unknown, reduction in sales
returns through faulty workmanship.
• Reduced stock and work-in-progress, enabling improved shopfloor layout,
greater space and a lower working capital requirement.
• Lower total manufacturing time, enabling the company to respond more
quickly to customer orders and to reduce work-in-progress further.
• Significantly improved machine utilisation rates, although the actual degree
of improvement is difficult to quantify.
• Increased capacity with the option to operate unmanned night working.
• Greater flexibility, enabling shorter production runs and faster re-tooling
and re-scheduling.
ADVANCED MANUFACTURING
TECHNOLOGY (AMT) INVESTMENT
A three-stage approach to analysing AMT capital projects:
1 Does the project fit well within the company’s overall corporate strategy?
2 Does the DCF analysis, based on the quantifiable elements of the decision,
justify the investment outlay?
3 Where the net present value calculated in stage 2 is negative, examine the
shortfall.
ENVIRONMENTAL ASPECTS OF
INVESTMENT
The steps involved in evaluating projects with environmental implications are:
1 Evaluate the projects using conventional capital appraisal methods.
2 Identify and incorporate statutory environmental costs as part of the
evaluation.
3 Assess the costs and benefits of other environmental measures. For example,
introducing anti-pollution measures should help reduce compensation claims.
4 Specify the internal controls to be introduced to ensure that pollution, etc., is
minimised during construction and implementation.
5 Assess the impact of the decision on shareholder wealth, ethical and social
responsibility goals.
Table 6.1
The importance of non-financial factors
related to strategic investment projects
Source: Alkaraan and Northcott (2006).
Figure 6.4
A simple capital budgeting system
Determination of the budget
• If the investment decision-making body is a sub-unit of a larger group, the

budget may be more or less rigidly imposed on it from above.
• For quasi-autonomous centres (divisions of larger groups with capital-
raising powers) and/or independent units, the amount to be spent on
capital projects is largely under their control, subject, of course, to
considerations of corporate control and gearing.
Search for, and development of,
projects
• Questions to be asked at the identification stage include the following:
1 How are project proposals initiated?
2 At what level are projects typically generated?
3 Is there a formal process for submitting ideas?
4 Is there an incentive scheme for identifying good project ideas?
• At this early stage, a preliminary screening of all investment ideas is usually
conducted.
projects
• Screening proposals addresses such questions as the following:
1 Is the investment opportunity compatible with corporate strategy? Does it
fall within a section of the business designated for growth?
2 Are the resources required by the project available (technical expertise,
human resource, finance, etc.)?
3 Is the idea technically feasible?
4 Is the idea socially acceptable?
5 Is it an environment-friendly project?
6 What evidence is available to suggest that it is likely to provide an acceptable
return?
7 Are the risks involved acceptable?
• As the quality of data used at the screening stage is generally poor, the
simple payback method is frequently used at this stage because it offers a
crude assessment of project profitability and risk.
projects
• At the definition stage of the capital investment process, detailed
specification of the investment proposal involves the collection of data
describing its technical and economic characteristics.
• A suggested investment proposal classification is given here:
• Replacement proposals are justified primarily by the need to replace assets
that are nearly exhausted or have excessively high maintenance costs.
• Cost reduction proposals (which may also be replacement proposals) are
intended to reduce costs through addition of new equipment or
modification to existing equipment.
• Expansion or improvement proposals relate to existing products and are
intended to increase production, service and distribution capacity, to
improve product quality or to maintain and improve the firm’s competitive
position.
• New product proposals refer to all capital expenditures pertaining to the
development and implementation of new products.
projects
• Strategic proposals are generated at senior management level and involve
expenditure in new areas, or where benefits extend beyond the investment
itself.
• Statutory and welfare proposals do not usually offer an obvious financial
return, although they may contribute in other ways, such as enhancing the
contentment, and hence productivity, of the labour force.
Evaluation and authorisation
• The evaluation phase involves appraisal of the project and decision

outcome (accept, reject, request further information, etc.).
• The capital appropriation request forms the basis for the final decision to
commit financial and other resources to the project. Typical information
included in an appropriation request is as follows:
1 Purpose of project– why it is proposed, and whether the project fits with
corporate strategy and goals.
2 Project classification– e.g. expansion, replacement, improvement, cost-saving,
strategic, research and development, health and safety, compliance and legal
requirements.
3 Finance requested– amount and timing, including net working capital, etc.
4 Operating cash flows– amount and timing, together with the main
assumptions influencing the accuracy of the cash flow estimates.
5 A=ractiveness of the proposal– expressed by standard appraisal indicators, such
as net present value, DCF rate of return and payback period calculated from
after-tax cash flows.
6 Sensitivity of the assumptions– effect of changes in the main investment inputs.

Other approaches to assessing project risk should also be addressed (e.g.
best/worst scenarios, estimated range of accuracy of DCF return).
7 Review of alternatives– why they were rejected? Are these alternatives
economically attractive?
8 Implications of not accepting the proposal– some projects with little economic
merit according to the appraisal indicators may be ‘essential’ to the
continuance of a profitable part of the business or to achieving agreed strategy.
9 Non-financial considerations– those costs and benefits that cannot be measured
in financial terms (political and social considerations).
• Following evaluation, the proposal is transmitted through the various

authorisation levels of the organisational hierarchy until it is finally
approved or rejected.
• The approval stage appears to have a twofold purpose:
1 A quality control function. As long as the proposals have satisfied the
requirements of all previous stages, there is no reason for their rejection other
than on political grounds.
2 A motivational function. The decision-maker forms a judgement
simultaneously on both the proposal and the person or team submitting it.
Monitoring and control
• Control is established by accounting procedures for recording expenditures.

Progress reports usually include actual expenditure; amounts authorised to
date; amounts committed against authorisations; amounts authorised but
not yet spent; and estimates of further cost to completion.
POST-AUDITING
• A post-audit aims to compare the actual performance of a project after, say,

a year’s operation with the forecast made at the time of approval, and
ideally also with the revised assessment made at the date of commissioning.
• The aims of the exercise are twofold: first, post-audits may attempt to
encourage more thorough and realistic appraisals of future investment
projects; and second, they may aim to facilitate major overhauls of ongoing
projects, perhaps to alter their strategic focus.
POST-AUDITING
• There are many problems with post-audits:

1 The disentanglement problem. It may be difficult to separate out the relevant
costs and benefits specific to a new project from other company activities,
especially where facilities are shared and the new project requires an increase
in shared overheads.
2 Projects may be unique. If there is no prospect of repeating a project in the
future, there may seem little incentive in post-auditing, since the lessons
learned may not be applicable to any future activity.
3 Prohibitive cost. To introduce post-audits may involve interference with
present management information systems in order to generate flows of suitable
data.
4 Biased selection. By definition, only accepted projects can be post-audited, and
often only the underperforming ones are singled out for detailed examination.
POST-AUDITING
5 Lack of cooperation. If the post-audit is conducted in too inquisitorial a fashion,

project sponsors are likely to offer grudging cooperation to the review team
and be reluctant to accept and act upon their findings.
6 Encourages risk-aversion. If analysts’ predictive and analytical abilities are to
be thoroughly scrutinised, they may be inclined to advance only ‘safe’ projects
where little can go awry and where there is less chance of being ‘caught out’ by
events.
7 Environmental changes. Some projects can be devastated by largely
unpredictable swings in market conditions.
POST-AUDITING
• What guidelines can we offer to managers who wish to carry out post-audit
from scratch for the first time or to overhaul an existing post-audit system?
1 When introducing and operating a post-audit, emphasise the learning
objectives and minimise the likelihood of its being viewed as a ‘search for the
guilty’.
2 Clearly specify the aims of a post-audit. Is it to be primarily a project control
exercise, or does it aim to derive insights into the overall project appraisal
system?
3 When introducing post-audits, start the process with a small project to
reveal, as economically as possible, the difficulties that need to be overcome in
a major post-audit.
4 Include information about a pre-audit in the project proposal. When the
project is submi>ed for approval, the sponsors should be required to indicate
what information would be required to undertake a subsequent post-audit.
Questions 3

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Corporate Finance and Investment

Decisions and Strategies

• Individual capital projects should be viewed not simply in isolation, but

• Foster Engineering Ltd is considering introducing a flexible manufacturing

• An incensed production engineer in Foster Engineering, on hearing that the

Source: Alkaraan and Northcott (2006).

• If the investment decision-making body is a sub-unit of a larger group, the

• The evaluation phase involves appraisal of the project and decision

6 Sensitivity of the assumptions– effect of changes in the main investment inputs.

• Following evaluation, the proposal is transmitted through the various

• Control is established by accounting procedures for recording expenditures.

• A post-audit aims to compare the actual performance of a project after, say,

• There are many problems with post-audits:

5 Lack of cooperation. If the post-audit is conducted in too inquisitorial a fashion,

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