The need for investment appraisal
The point that money can be wasted and financial strategies fail is by now probably obvious; there is a continuing need for robust appraisal processes in businesses of whatever size. The arithmetic and measure of appraisals are used in many aspects of business and strategic decision making:
lease versus buy;
replace or refurbish;
invest or not;
value intangibles such as brands;
check for impairment.
Arithmetic of appraisal - discounting cash flows
The worth, value or cost of a project depends on two variables: the actual amounts of cash received or paid, and the timing of the receipts or payments.
Appraising investments involves estimating both the future amounts and the timing of the amounts of cash flows; this is the difficult part of investment, capital expenditure or project appraisal. Further, a small change in the discount rate to be applied often has a disproportionate effect on outcomes, and thus decision making and the application of the 'correct' rate is important. However, the arithmetic is simple and also accurate.
Time value of money
The timing of receipts or payments is important because an amount of money received today is worth more than the same amount received later in time.
If you were offered 1,000 now or 1,000 in one year's time, you would obviously take the money today. However, what if you were offered 1,000 today or 1,700 in one year's time? Which would you choose? Firstly, there is a cost of money, the so-called time value of money. Money never comes free. One way of thinking of money is as a commodity (really a means of trading in other commodities) and thus in managed economies it has an appropriate scarcity value. If there were no inflation in economies, the 'real' cost of money, the real interest rate, might in normal times be in a range 3-4 per cent. For practical business purposes, the rate required will be the bank borrowing rate as an absolute minimum or more likely the opportunity cost of money - equal to or greater than the cost of capital of the company. In simple terms, the cost of capital of a business is the weighted average of the rate of return required by shareholders and lenders.
For examples in this chapter we shall use typical UK or US required rates of 12-20 per cent.
Returning to the above example, if you could invest the 1,000 today to give a rate of return of, say, 15 per cent, it would be worthwhile to wait for the 1,700. The 1,000 today would only be worth 1,150 in a year's time at the 15 per cent rate of return. However, there is also the question of risk, and it might be better to accept the 1,000 today rather than hold out for the 1,700 - a bird in the hand! The concept of certainty of cash flows in and out underlies what is an obvious strategy as regards investments - spend as little as possible at the outset and maximize receipts as early as possible.