Evaluation of Investment Decision

The presently available literature suggests various models and equation of evaluation of an investment decision. It is often very difficult to choose among several alternative projects and find an optimal decision. The decision-makers usually do not decide about one single project, thus, a bundle of projects or alternatives. Each of these projects includes a number of individual projects, which not only incorporated the technology investment, but potential research and development, personnel training and deployment. When the decision-maker is

26 Gan L. (2005). “Green Electricity Market Development: Lessons From Europe And The US”, Energy Policy, Vol. 35, Issue 1, January 2007, pp.144-155.

27 Fargione, J. (2008). “Land Clearing and the Biofuel Carbon Debt”, Science Express, February 2008: Vol.

319. no. 5867, pp. 1235 – 1238.

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dealing with greater amount of alternatives, he has to foresee what all of these projects are, however, he needs to recognize the economic value each of the project can deliver to the enterprise. Even if it is often impossible to foresee all the factors influencing the individual projects, the important step in their evaluation remain the objective of maximization of economic value over the period of time [Favaro, 1999]. Investment decision techniques are usually referred to as methods of capital budgeting, which seek to maximize the wealth of shareholders. The projects the managers face to choose from can be characterized as mutually exclusive, independent or contingent projects [Copeland et.al. 2005]. Mutually exclusive projects are a set or bundle of project from which only one project; respectively alternative can be chosen, naturally, the project that maximizes the shareholders` value. In the case of Chemosvit Energochem a.s. the set of mutually exclusive projects/alternatives was selected in the year 2007, and respectively, only one of these projects can be chosen for the final realization and implementation. Many authors propose rules such as the net present-value, payback method, accounting rate of return or internal rate of return for evaluation of an investment decision [Copeland, 2005; Hirschleifer, 1958; ].

On the other hand, several scholars reject the internal rate of return as an investment criterion [Hirschleifer, 1958; Copeland, 2005], as it is often in contradiction to the results of net present value. Even if there are various supporters for the net present-value rules, this is often only a partial indicator of optimal investment and under some conditions it gives incorrect results [Hirschleifer, 1958]. Furthermore, it implicitly assumes precommitment and therefore ignores sources of additional value that may be contained in the managerial flexibility of project improvement over the period of time and so net present value can undervalue the alternatives [Copeland et.al, 2005].

Cash flow statements are often used to summarize activities over a span of time and enable

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the management to predict the future cash flows as well as to determine the performance of a company over a period of time. Cash flow from investment activities in which a company acquires a dispose of plant, property or equipment [Horngren et.al, 2006]. The investment decisions are reflected into the cash flow and provide so better monitoring abilities. In the case of Chemosvit Energochem a.s. the investment decision incorporates new technologies, equipment as well as buildings. Therefore, it is important to estimate the cash flow over the period of time and compare the individual results for each of the alternatives. The forecast of costs and benefits and their comparison with cash flow over the period of time are according to Favaro et.al (1999) “the best available measure of the economic worthiness of the investment” (pp.10). However, these measures are most suited for the businesses with foreseeable future and the stable operations over long time. Currently, numerous techniques of cash flow forecasting and management exist; however, many of them differ in the accuracy and detail, as well as the method of time and money integration [Park et.al. 2005].

The simplest method of provided the picture about the projects over a specific period of time is to construct exact cash flow of each alternative [Copeland et.al, 2005, pp. 36]. This method offers fundamental comparison of alternatives with necessity to estimate the investment expenses, operational revenue and expenses over the period of time, which enables to develop a balance of cash flow over the period. To provide a better measure for comparison, a cumulative balance of cash flows in the span of time may supply the management with better overview about the projects and maximization of shareholders`

value. The balance cash flow incorporates depreciation, interest, taxation and other payments and so provides the “clean” view over the investment decision in the future. In this manner, the cash flow for investment decision purposes includes many incremental cash flows attributable to the project.

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The payback method is simply a number of years it takes to recover the initial cash outlay on a project. The period of payback of a project to be invested in is the amount of time it will take for the after-tax cash inflows from the project to accumulate to an amount that covers the original investment. In the case of uneven cash flows during the period, the after-tax cash flow has to be accumulated on a year-to-year basis. The payback period will be defined after the accumulated amount equals the initial investment.

The payback method has indeed some disadvantages, when comparing with other methods of measurements of investment decision; however, it is widely used in the practice [Hilton, 2008]. The first reason is that it provides a roughly screening of the investment alternatives, without considerable cost and time requirements. The management can recognize from the payback period, if the project meets the minimal criteria set for the evaluation and may so reject this alternative in the very beginning of the evaluation process. Moreover, for small or medium enterprises cash is often substantial and crucial tool to proceed with business. If the payback period of an investment is too long, the enterprise will lack essential cash for its operations.

The usage of payback method itself is partially arbitrary as it ignores the cash flows after the date of payback, which is chosen as cutoff date. Furthermore, the payback method is often use to evaluate small investment decisions as it is much more easier to decide basing on the payback. Thus, in the reality, payback method and net present value often lead to the same decisions even though it is ignoring possible high cash inflows beyond the payback period [Ross et.al, 2007]. The companies usually combine several measurements of evaluating the investment decisions. Payback method is often used in conjunction with cash flow analysis, as it is not wise to rely only on one method itself [Copeland et.al, 2005]. This thesis will concentrate on the cash flow analysis of each alternative over the period of 8

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years. Consequently, I will compare the cumulative balance of cash flow of all alternatives.

To provide more accurate results, the cumulative balances will be compared with payback method and subsequently the choice of alternative will be made [Ross et.al, 2007].

Due to the time limitation of this thesis, the other methods of investment decision evaluation were not incorporated. Except for the net present value or internal rate of return, the return on investment analysis would be appropriate. Return on investment is one of the most common “investment-center performance measure” [Hilton, 2008] and it aims to achieve clarity in the decision-making process. The indicator is often used to analyze the economic value of projects executed in the pursuit of business strategy adopted by a firm [Erdogmus et.al, 2004]. The calculation of return on investment organizes projects` costs and benefits, or alternatively the cash flow of the firm, into a useful profitability measure.

The cost-benefit analysis allows to translate the measured or estimated data into monetary terms and forms so the basis for valuation. In conjunction with the cash flow analysis and payback method, the analysis can provide more accurate results. However, the scope of this thesis is not interfering behind these two measures and so it leaves the space for the further research in this topic.

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