Making your investments pay off - Investment decisions in practice (Part I)

Investment decisions are among the most important corporate decisions. Poor investments can have a fatal impact on long-term company development. It is therefore all the more important to consider all relevant aspects (taxes, investment incentives, capacity and utilisation planning, logistics, effects on personnel, etc.). Investments must pay off in the long term – business investment calculation provides several different models for this purpose.

Given that investment decisions are often of different types, an overview of the various forms of decisions will first be provided:

• Election decisionWhich investment of several alternatives should be realised?
• Replacement decisionShould an investment good be replaced by another (new) one?
• Investment duration decisionHow long should an investment property be used for?
• Programming decisionsWhich combination of multiple possible investment projects should be implemented?

The downstream decision-making and implementation process for investment projects can typically be divided into several phases:

1. Planning phase (Investment incentive, showing alternative courses of action, information gathering, feasibility study, economic calculations)
2. Realisation phase (Investment decision-making, Investment decision implementation)
3. Monitoring and control phase (Investment appraisals, budget vs. actual comparisons, investment controlling)

Investment appraisal techniques assist in preparing the necessary decisions numerically at all stages, supporting arguments, and enabling the comparison of different alternatives. In theory and practice, a distinction is made between static and dynamic Methods are distinguished. The first part of this contribution presents the static methods, which are of great importance in practice for an initial rough classification of investment opportunities due to their simple applicability and comprehensibility.

1. Cost comparison calculation: "Choose the investment with the smallest (average) costs!" To compensate for cost fluctuations, the focus is on average period costs. This method is purely cost-focused, meaning effects on the revenue side are disregarded. The instrument is applicable when equivalent products with the same selling prices can be produced, and thus only costs can be influenced.
   
2. Profit comparison calculation: "Choose the investment with the greatest (average) profit and forgo projects that bring losses!" This focuses on average period profits. It is not necessary to produce equivalent products, as the differences will be taken into account in the revenues anyway. A profit comparison calculation can be carried out according to the following (simple) scheme:
   
   

   	Redeem
   -	Depreciation
   -	Operating costs/production costs (materials, personnel, etc.)
   =	Capital gain
   -	Interest on borrowed capital
   =	settlement profit
   -	Imputed interest on equity
   =	notional profit

   
   
3. Profitability comparison calculation: "Choose the investment with the highest (average) return! Reject projects whose returns are less than the required minimum rate of return!". This model determines the ratio between the average profit per period and the average capital employed:
   
   Profitability = Period Profit / Capital Employed
   
   The higher the profitability of an investment, the more advantageous it is. Profitability calculations can be used to compare projects with different investment costs. Profitability calculations therefore sensibly supplement profit comparison calculations. The profitability of the total capital (equity and debt capital) is determined when investments are to be compared independently of their financing. If the equity commitment for financing is already fixed, only the average equity is used in the denominator.
   
4. Static Amortisation Calculation: "Choose the investment with the shortest payback period!". This determines the time it takes to recoup the investment costs from surplus revenue.
   
   Amortisation period = Investment costs / average profit per annum (before depreciation)
   
   Payback period calculations are often used in practice to assess the risk of investment projects. Consequently, the longer the payback period, the higher the risk. The payback period can be used to answer the following questions:
   • Can the investment costs be recovered within the planned useful life?
   • To what extent is there coverage with industry-specific experience values?

Overall, it should be noted that static methods are well-suited for rough estimates due to their easy applicability and comprehensibility, and should therefore be carried out as a first step in any case. However, dynamic methods should be used for further in-depth examination of individual investment alternatives. These will be discussed in detail in the next issue.

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