1

Identify and explain the key stages in the capital investment decision-making process, and
the role of investment appraisal in this process. (7 marks)

Answer

Key stages in the capital investment decision-making process

A typical model for investment decision making has a number of distinct stages.

1. Origination of proposals,
2. Project screening,
3. Analysis and acceptance,
4. Monitoring and review.

Origination of proposals

Investment proposals may come from an analysis of strategic choices, analysis of the business
environment, research and development or legal requirements.

The overriding feature of any proposal is that it should be consistent with the organisation’s
overall strategy to achieve its objectives. Some alternatives will be rejected early on. Others will
be more thoroughly evaluated.

Project screening

Each proposal must be subject to detailed screening. To enable a qualitative evaluation of a

proposal to be made, a number of key questions might be asked before any financial analysis is
undertaken. For example, what is the purpose of the project, does it 'fit' with the organisation's
long-term objectives, does the project expose the organisation to unnecessary risk, how long
will the project last and what factors are key to its success.

Only if the project passes this initial screening will more detailed financial analysis begin.

Analysis and acceptance

Investment proposals then need to be analysed in depth to determine which offer the most
attractive opportunities. This analysis will include a financial analysis of the project, a comparison
of the outcome of the financial analysis to predetermined acceptance criteria and a
consideration of the project in the light of the capital budget for the current and future
operating periods.

The most suitable proposals are then passed to a senior authority for consideration and
approval. Go/no go decisions on projects may be made at different levels within the
organisational hierarchy, depending on the type of investment, its perceived riskiness and the
amount of expenditure required.
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Monitoring and review

During the project's progress, project controls should be applied to ensure that capital spending
does not exceed the amount authorised, the implementation of the project is not delayed and
the anticipated benefits are eventually obtained.

Explain the rationale for implementing capital investment monitoring systems and post-
completion audits.

Co’s investment plans are based on a detailed analysis of all cost and revenue assumptions,
projects lambda and kappa highlight failings in the appraisal and implementation phases.

Capital investment monitoring (CIM)

Capital investment monitoring involves reviewing the implementation of an investment project

to ensure it progresses according to the original investment plan, timescale and budget. This
involves assessing the risks associated with the implementation phase and identifying deviations
from the investment plan so that remedial action can be taken where necessary. Controls should
be established to ensure effective delivery of the project. Effective investment monitoring may
have avoided the cost overruns and time delays experienced by Hathaway Co’s project lambda.

Post-completion audit

A post-completion audit is an objective, after the fact, appraisal of all phases of the capital
investment process regarding a specific project. Each project is examined from conception until
as much as a few years after it has become operational. It examines the rationale behind the
initial investment decision, including the strategic fit, and the efficiency and effectiveness of the
outcome. The key objective is to improve the appraisal and implementation of future capital
investment projects by learning from past mistakes and successes. An effective post-completion
audit may have identified the reasons behind the failure of Hathaway Co’s project kappa to
achieve its forecast revenues.

Note: Credit will be given for alternative and valid discursive comments.
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Discuss the non-executive director’s understanding of net present value and explain the
importance of other measures in providing data about an investment’s short and long-
term performance. (5 marks)

The non-executive director has highlighted the importance of long-term maximisation of

shareholders’ wealth. The net present value is the most important indicator of whether an
investment is likely to do that. However, the assessment of investments using net present value
has to be modified if the company is undertaking a number of different investments and capital
is rationed. It is not necessarily the case that the investments with the highest net present value
will be chosen, as account has to be taken of the amount of capital invested as well.

However, investors are not necessarily concerned solely with the long term. They are also
concerned about short-term indicators, such as the annual dividend which the company can
sustain. They may be concerned if the company’s investment portfolio is weighted towards
projects which will produce good long-term returns, but limited returns in the near future.

Risk will also influence shareholders’ views. They may prefer investments where a higher
proportion of returns are made in the shorter term, if they feel that longer term returns are
much more uncertain. The NPV calculation itself discounts longer term cash flows more than
shorter term cash flows.

The payback method shows how long an investment will take to generate enough returns to pay
back its investment. It favours investments which pay back quickly, although it fails to take into
account longer term cash flows after the payback period. Duration is a better measure of the
distribution of cash flows, although it may be less easy for shareholders to understand.
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Discuss the factors that a company should consider in choosing between equity finance
and debt finance as a source of finance.

There are a number of factors to be considered in the choice between debt and equity finance.

1. Gearing and financial risk

2. Objectives
3. Security
4. Expectations
5. Control

Gearing and financial risk

Debt finance tends to be relatively low risk for the debt holder as it is interest-bearing and can
be secured. The cost of debt to a company is therefore relatively low.

But the greater the proportion of debt, the more financial risk to the shareholders of the
company so the higher is their required return.

The relative acceptability of these levels of gearing depends on desired level of financial risk.

Objectives

If the primary financial objective is to maximise shareholder wealth, it should aim to minimise its
WACC. This can be achieved by increasing the amount of debt in its capital structure. The limit
to this is the point at which gearing is so high that costs of financial distress are incurred. For
example, bankruptcy risk and restrictive covenants imposed by debt providers.

Security (Secure the debts with assets)

The choice of finance may be determined by the assets the business is willing or able to offer as
security. This can be in the form of a fixed charge on specific assets, or a floating charge on a
class of assets. More information would be needed on the availability of such assets. Investors
are likely to expect a higher return on unsecured debt to compensate them for the extra risk.

Expectations

If economic conditions are buoyant (optimistic), Co will be more willing to take on extra debt
and commitment to pay interest than if business is suffering in an economic downturn. Lenders
are also likely to be more cautious and less willing to lend if the economy is struggling.

Control

A key advantage of debt finance for a company’s shareholders is that existing shareholdings will
not be diluted but debt providers may however impose covenants, restricting dividend payment,
EPS, gearing ratios etc.
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However, equity finance by rights issue will also not dilute existing patterns of ownership and
control provided existing shareholders take up their rights.

If the amount of new equity finance required is sufficiently large, new shares may be issued to
new investors, for example in a placing, and this will dilute existing shareholdings.

Finance through asset securitization

Finance through Asset Securitization

Core Concept:

Asset securitization involves pooling together illiquid assets (like mortgages, car loans, or credit
card receivables) and transforming them into marketable securities. These securities are then
sold to investors, providing the originator with immediate cash flow.

Illustrative Example: Mortgage-Backed Securities (MBS)

1. Origination: A bank originates several mortgage loans to homeowners. These

mortgages are assets on the bank's balance sheet, but they tie up capital and limit the
bank's ability to lend further.
2. Pooling: The bank pools these mortgages together into a Special Purpose Vehicle (SPV),
a legally separate entity.
3. Securitization: The SPV issues bonds (MBS) backed by the cash flows (principal and
interest payments) from the underlying mortgage pool.
4. Sale to Investors: The MBS are sold to investors who are essentially buying a claim on
the future cash flows from the mortgages.
5. Cash Flow: As homeowners make their mortgage payments, the cash flows through the
SPV to the investors who hold the MBS.

Benefits for the Originator (Bank):

 Liquidity: The bank receives immediate cash by selling the MBS, freeing up capital for
further lending.
 Risk Transfer: The credit risk associated with the mortgages is transferred to the
investors who buy the MBS.
 Balance Sheet Management: The bank can improve its balance sheet ratios by
removing the mortgages from its books.

Benefits for Investors:

 Diversification: MBS offer exposure to a diversified pool of mortgages, reducing

individual loan risk.
 Yield: MBS can offer attractive yields compared to other fixed-income securities.
 Liquidity: MBS are generally traded in liquid markets.
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Key Considerations:

 Credit Risk: The value of MBS is tied to the credit quality of the underlying mortgages. If
homeowners default, the cash flows to investors may be impacted.
 Interest Rate Risk: MBS are sensitive to interest rate changes. If interest rates rise, the
value of existing MBS may fall.
 Complexity: The structuring and valuation of MBS can be complex.