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BUSS3 A* Evaluation - Investment Appraisal and the Power of Application

Saturday, January 05, 2013
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The need to stay 100% in context when writing BUSS3 answers is well appreciated by A grade students. As we've said many times, good application opens the door to good analysis and pushes student answers up to the highest levels of evaluation. 

Nowhere is this more important than in the use of investment appraisal. This is because investment appraisal is all about making forecasts about the future. Those forecasts absolutely have to take account of the nature of the case study firm and the market in which it operates.  Investment appraisal calculations also have to make use of data based on assumptions usually made by the case study management.  The A* answer for a BUSS3 answer that makes use of investment appraisal evidence should therefore make best use of the opportunity to question the assumptions made by management and the reliability of the forecast data used.

Let's take a simple example to help explain why application is so important here.

Imagine we have two case study firms who have produced investment forecasts which can be summarised as follows:

Business A:

  • Market:  Fast growth and subject to rapid change
  • Management:  Young, energetic & inexperienced
  • Investment: £1 million
  • Payback period: 1.5 years
  • NPV: £+350k using a 10% discount factor

Business B:

  • Market:  Very low growth and highly predictable
  • Management:  Experienced and cautious
  • Investment: £1 million
  • Payback period: 2.5 years
  • NPV: £+10k using a 20% discount factor

Looking at the two businesses above, if you could go ahead with just one investment project, which one would it be?

The standard textbook answer is to say that Business A has the best investment opportunity of the two. The payback period for the investment is just 1.5 years (i.e. the cash outflows of the investment are recouped in less than two years). The NPV of the investment is positive (£350k) which indicates that it is worthwhile taking on. Operating in a fast-growth market, this looks like a business that needs to take some risks and the proposed investment looks promising.

Or does it? Could Business B be a better bet? Possibly. It's all about APPLICATION.

Remember that evaluating investment appraisal is all about considering the future. The investment involves taking a risk. But does the data suggest the risk is worthwhile? Can the assumptions that have been made be relied upon? Are they likely to be too optimistic or too pessimistic?

The two most important factors to consider are the management of the case study business and the market in which it operates.

Take a look at Business B

Management are experienced and cautious. They're likely to have put together some relatively cautious forecasts about the investment. I suspect that actual returns (cash flows, profits) might turn out to be better than they've assumed - which would mean that their investment appraisal could be too pessimistic at the moment

Business B also operates in a low growth and highly predictable market. That doesn't sound very exciting, but it makes for more reliable market forecasts which again might lead to better quality investment appraisal.

By contrast, students using the skill of application might express some reservations about Business A's investment project. Sure, the calculations look positive (and it is worth mentioning this in an exam answer). However, the smart student would reflect on the evidence that the investment project might produce results that are much worse than forecast. 

For example, we are told that Business A operates in a fast growth market that is subject to rapid change. That ought to be a warning sign. Rapid change implies a market in which it is difficult to make accurate forecasts. You might expect profit quality to be low (more volatile) and cash flows to change significantly. We're also told that Business A's management are energetic but inexperienced. This is another warning sign that the investment appraisal results might be too optimistic and a little unreliable. It might also explain why they used a relatively low discount factor of 10% for their NPV calculations rather than Business B who used a higher discount factor (which takes better account of risk). In general, using a low discount factor tends to make NPV calculations look more favourable and can lead to a firm accepting a project when it might be better to reject it.

My hunch is that Business B's investment project is more attractive than Business A. In a sense it doesn't matter. What matters is that in BUSS3 answers about investment appraisal you take some time to address the context of the case study firm, management and market and how that might influence whether the project is likely to achieve the returns forecast for it.

It's all about the case study.

It's all about application! 




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