Strategic Investment Decision Making

A key ingredient of the strategic long term plan is the strategic financial plan (sometimes referred to as ‘Investment Decision Planning’, which essentially estimates the investment required in fixed assets like plant, machinery, working capital, Research & Development (R &D)  etc. required to support the strategies of the firm. The plan then measures the net cash flows generated by this investment under conditions of risk, uncertainty  and competition to see if the investment is able to create or  maximise shareholder wealth (see below) 

This methodology used is called Discounted Cash Flow (DCF) analysis which basically recognises that the future cash flow benefits of any strategy incur upfront investment including incremental operational and financing costs. The method recognises the time value of money based on the following rules;

1. A dollar earned today is worth more than a dollar earned tomorrow due to the inherent cost of the opportunity missed of investing a dollar today;
2. A distant dollar (a dollar earned tomorrow) is always riskier than a dollar in your hand today, as the future is always risky and uncertain;

The first step therefore is to make an estimate of the projects Cost of Capital (also called the ‘WACC’ or weighted average cost of capital). This is the cost of raising money to finance a particular strategy taking into account the firm’s unique risk, the market risk and the capital structure of the firm (the weightage of debt and equity).

The next step is to Discount the Cash flows (See DCF above) by actually reducing these future cash flow projections, to adjust the ‘time value’ of money and the risk of earning cash flows at a future date, the principle being the longer the time to earn a particular net cash return on an investment, the greater the reduction in value over the time horizon of the project;