Position Paper: Strategic Investment Decision-making

By: Deepti Tripathi

140101049
Section-A

Introduction
The fundamental success of a strategy depends on three critical factors: a
firms alignment with the external environment, a realistic internal view of its
core competencies and sustainable competitive advantages, and careful
implementation and monitoring.
This paper takes the position that financial goals and metrics help firms
implement strategy and track success. It explains how finance, financial
goals, and financial performance can play a more integral role in the
strategic planning and decision-making process, referred as Strategic
Investment Decision-making. It then highlights the problems with
traditional approach to decision-making and modern approaches developed
for the same.

Background
If we look at any organization today, most of what we see is the outcome of
past strategic investment decisions. The firms assets, tangible or intangible,
can all be traced back to investment decisions made in the past.
More important is the fact that strategic investment decisions often involve a
very substantial outlay of resources, the success or failure of which can have
long term consequences for the firm. Specifically, adopting a given strategic
investment strategy may result in a major departure from the firms previous
operations, significantly affecting its future financial performance and
altering its risk profile as well.
Strategic investments are responsible for turning the firms strategic
positioning into business performance and ultimately into shareholder value.
Indeed, it is through strategic investments that shareholder value is created

and augmented. Although such decisions are made relatively infrequently,

they are the backbone of strategy formulation and implementation. As such,
investment decision-making is part and parcel of a firms strategy and are of
vital importance to the future success of the firm

Strategic investment decisions -defined

Strategic investment decisions (SIDs) are the decisions on investments which
have substantial effects on the long term financial and operational
performance of companies, and which have a big impact on the competitive
ad-vantage of firms .Strategic investments generally have influence on the
product or service sets of companies, and geographical scope and dispersion
of their operations. Company acquisitions and mergers, the introduction of
new product lines, the installation of new manufacturing processes and
business technologies are typical examples for SIDs.
The complexity of SID making processes grabs the attention of researchers
and academicians. While older studies develop models to evaluate
investment projects only from financial perspectives, newer studies try to
develop models that evaluate strategic outcomes of the in-vestments and
emphasize the importance of integrating financial and strategic analysis
tools when making SIDs. The strategic investment decision making process is
arguably one of senior managements greatest challenges. There is a critical
need to get these decisions right. For on the one hand, if the decision proves
successful, the firm reaps major strategic and operational advantages. On
the other hand, should the decision be wrong, either an important
opportunity is forever lost (by virtue of the firms failure to invest when in
hindsight it should have) or it has needlessly squandered substantial
resources (by virtue of making a fruitless investment).
A large number of studies in the related literature also search which
appraisal methods are being used to make investment decisions, which one
is preferred most and what affects the method choice. The mentioned factors
that affect the method selection are size or characteristics of the company,
type of the investment decision, management style and business
environment.

The Role of Finance

Financial metrics have long been the standard for assessing a firms
performance. The balance scorecard supports the role of finance in
establishing and monitoring specific and measurable financial strategic goals
on a coordinated, integrated basis, thus enabling the firm to operate
efficiently and effectively. Financial goals and metrics are established based
on benchmarking the best-in-industry and include:

1. Free Cash Flow

This is a measure of the firms financial soundness and shows how efficiently
its financial resources are being utilized to generate additional cash for
future investments. It represents the net cash available after deducting the
investments and working capital increases from the firms operating cash
flow. Companies should utilize this metric when they anticipate substantial
capital expenditures in the near future or follow-through for implemented
projects.

2. Economic Value-Added
This is the bottom-line contribution on a risk-adjusted basis and helps
management to make effective, timely decisions to expand businesses that
increase the firms economic value and to implement corrective actions in
those that are destroying its value. It is determined by deducting the
operating capital cost from the net income. Companies set economic valueadded goals to effectively assess their businesses value contributions and
improve the resource allocation process.

3. Asset Management
This calls for the efficient management of current assets (cash, receivables,
inventory) and current liabilities (payables, accruals) turnovers and the
enhanced management of its working capital and cash conversion cycle.
Companies must utilize this practice when their operating performance falls
behind industry benchmarks or benchmarked companies.
4. Financing Decisions and Capital Structure
Here, financing is limited to the optimal capital structure (debt ratio or
leverage), which is the level that minimizes the firms cost of capital. This
optimal capital structure determines the firms reserve borrowing capacity
(short- and long-term) and the risk of potential financial distress. Companies
establish this structure when their cost of capital rises above that of direct
competitors and there is a lack of new investments.

5. Profitability Ratios
This is a measure of the operational efficiency of a firm. Profitability ratios
also indicate inefficient areas that require corrective actions by
management; they measure profit relationships with sales, total assets, and
net worth. Companies must set profitability ratio goals when they need to
operate more effectively and pursue improvements in their value-chain
activities.
6. Growth Indices
Growth indices evaluate sales and market share growth and determine the
acceptable trade-off of growth with respect to reductions in cash flows, profit
margins, and returns on investment. Growth usually drains cash and reserve
borrowing funds, and sometimes, aggressive asset management is required
to ensure sufficient cash and limited borrowing. Companies must set growth
index goals when growth rates have lagged behind the industry norms or
when they have high operating leverage.

7. Risk Assessment and Management

A firm must address its key uncertainties by identifying, measuring, and
controlling its existing risks in corporate governance and regulatory
compliance, the likelihood of their occurrence, and their economic impact.
Then, a process must be implemented to mitigate the causes and effects of
those risks. Companies must make these assessments when they anticipate
greater uncertainty in their business or when there is a need to enhance
their risk culture.

8. Tax Optimization
Many functional areas and business units need to manage the level of tax
liability undertaken in conducting business and to understand that mitigating
risk also reduces expected taxes. Moreover, new initiatives, acquisitions, and
product development projects must be weighed against their tax implications

and net after-tax contribution to the firms value. In general, performance

must, whenever possible, be measured on an after-tax basis. Global
companies must adopt this measure when operating in different tax
environments, where they are able to take advantage of inconsistencies in
tax regulations

Traditional approaches to strategic investment appraisal - which include

payback, accounting rate of return, return on investment, residual income,
and discounted cash flow - have been criticized on a number of grounds.
Some of the chief criticisms are their narrow perspective, exclusion of
nonfinancial benefits, overemphasis on the short-term, faulty assumptions
about the status quo, inconsistent treatment of inflation, and promotion of
non-value adding behaviour. Each of these criticisms is discussed in turn.
Investment proposals are often viewed through an exceedingly narrow
decision-making lens. Proposals are examined almost invariably from the
sole perspective of the investing department. As such, they often fail to
recognise the benefits (for example, reductions in indirect labour and
inventories) that materialise outside of the investing department. A good
example is the introduction of computer-aided design / computer-aided
manufacture (CAD/CAM) systems. While a CAD/CAM proposal is typically
initiated by the design department, such an investment will likely benefit not
only the design department's productivity, but manufacturing's as well. Yet
often these cross-functional and cross-departmental benefits go
unrecognised.
A second problem with the use of traditional investment appraisal techniques
is their inability to account for the nonfinancial benefits that frequently
characterise strategic investments. In particular, such issues as increased
manufacturing flexibility or being more efficient at providing information are
seen as esoteric and are unable to be fitted into the financial calculus of

traditional appraisal models. Likewise, terminal project values that are

difficult to quantify for example, investments that pertain to system design,
data base development, or software - are commonly awarded a value of zero.
Such an approach is highly capricious and foolhardy.
A third problem with traditional investment appraisal techniques is their
short-term focus. Many strategic investments take many months, if not
years, to become fully operational. A flexible manufacturing system (FMS),
for example, requires that a number of interactive interfaces be aligned with
one another before full performance of the system is achieved.
Unfortunately, traditional appraisal techniques display an impatient regard
for long lead times and snuff out such projects in their infancy.
A fourth problem with traditional investment appraisal techniques is the
assumptions that underlie the status quo alternative against which strategic
investments are commonly compared. It is generally assumed that the
current competitive position will remain unaltered if the strategic investment
is not undertaken. But this assumption is not necessarily true .It is only true
if the cost, quality, flexibility, and innovation features offered by one's
competitors also remain unchanged.
A fifth problem with traditional investment appraisal techniques is the often
inconsistent treatment that is given to inflation. On the one hand, an
allowance is made for the financing and opportunity costs associated with
inflation. On the other hand, seldom are allowances made for the increased
cash flows that are likely to accrue (primarily through higher sales prices).
Such an inconsistent approach to the treatment of inflation underestimates a
project's likely return.
A sixth problem with traditional investment appraisal techniques is the
dysfunctional, non-value adding behaviour that such techniques often

engender. Managers who submit investment proposals frequently engage in

fanciful calculations. Aware of the high hurdle rates that senior managers use
to evaluate and select among strategic investment proposals, managers who
submit investment proposals stretch assumptions to their utmost limit and
sometimes beyond.
In summary, there are a number of apparent flaws with traditional
investment appraisal techniques. Yet, in spite of these flaws, such techniques
continue to be relied upon. As a consequence, there is the possibility not only
for misguided investment decisions, but also the possibility of a perversion of
senior managers' business imperative. Instead of investing in the company's
long-term core business, senior managers become side-tracked and start
investing for short-term cash flows.

Alternative approaches to evaluating and selecting

strategic investment proposals
There are two basic approaches that can be taken to developing alternative
strategic investment appraisal techniques. The first approach involves
modifying the traditional investment analysis framework. In particular, its
various technical shortcomings (e.g., inflation inconsistencies, the use of
inappropriately high discount factors, etc.) are corrected and its narrow focus
is expanded to include commonly neglected benefits (e.g., improvements in
flexibility, improvements in information quality and timeliness, etc.).
The second approach involves reliance on analytical frameworks that
represent significant departures from the traditional approach. Among these
different approaches are strategic cost management, the multi-attribute
decision model, value analysis, the analytical hierarchy method, the R&D
method, and the uncertainty method.

New-age evaluation methods

Strategic cost management
Strategic cost management (SCM) attempts to substantially broaden the
traditional financial analysis with an explicit consideration of strategic issues.
SCM seeks to manage costs for both financial and competitive advantage
and for both long- and short-term control. The accomplishment of this aim is
supported by its integration of the fields of management accounting,
production, and strategic planning. As such, SCM provides the informational
fuel for powering the organizations formulation of strategies, communication
of the strategies throughout the organization, development and execution of
tactics to implement the strategies, and development and implementation of
strategic controls.
SCM includes a three-part analysis: value chain analysis, competitive
advantage analysis, and cost driver analysis. From these analyses, managers
begin to gain insights into such important questions as What will be the
effect of the strategic investment decision on the firms ability to
manage/enhance the value chain?, What competitive advantages can be
gained from adoption of the strategic investment decision?, Does the
strategic investment decision promote factors which undergird the firms
order winning criteria?, and Does the strategic investment decision augment
important executional cost drivers and/or maintain the optimal nature of the
firms structural cost drivers?.
Multi-attribute decision model
The multi-attribute decision model (MADM) attempts to develop a general
measure of utility, where utility is defined as the satisfaction of an
individual's or set of individuals' preferences. A distinct advantage of this
model is that it is able to assess an investment's impact even when some of
the project's factors cannot be estimated in dollars.

To construct a MADM, a list of factors that are deemed important in judging

an investment is made. For example, financial measures such as payback
and NPV may appear, as well as such nonfinancial measures as reduced
complexity, improved information, and enhanced company image. A
weighting, which represents a factor's importance to the company, is then
assigned to each factor and scaled so that the combined weightings equal
100.
Ratings are next assigned to the factors based on beliefs about the effect
that the alternative courses of action (including the status quo) will have on
each factor.
The final step of MADM involves the calculation of a total score for each
course of action. This is performed by multiplying each factor weight by the
cross product of its rating and likelihood to calculate the individual factor
scores and then summing these factor scores to arrive at an aggregate score
for each alternative.

Value analysis and the analytical hierarchy method

There are two additional analytical techniques, called value analysis and the
analytical hierarchy process, that are very similar to MADM.
The value analysis method typically relies on a Delphi technique. The Delphi
technique begins with the selection of a group of "experts." For example, if a
proposed strategic investment involves the introduction of a new
organisation-wide IT system, then a representative group of managers from
throughout the organisation would be appropriate.

Each member of the Delphi group is asked to list the benefits that would
accrue from the adoption of the proposed investment. Aggregate group
responses - whereby no one individual's response can be detected - are fed
back to all group members.
Research and development method
The research and development (R&D) method views proposed strategic
investments less as capital investment candidates and more as applied
research and development projects, which require further experimentation
and testing before a decision can be made about their practicality and
usefulness. Hence, the name R&D method.
The R&D method is composed of two separate stages. The first stage seeks
to study, simulate, and estimate the proposed investment's benefits. Based
on an evaluation of these benefits, a decision is made to either continue
proceeding with an assess-ment of the proposed investment or stop
altogether.
The second stage of the R&D method seeks to determine if the project's total
costs can be maintained below the level of expected benefits. Such a
determination is often made by implementing the project in a particular
segment or operation of the organization. If the results prove positive, the
next step is to use the acquired cost/benefit data to assess the likely impact
of fully adopting the proposed investment.
There are two distinct advantages gained from using the R&D method. First,
the preliminary working model offers real data on the costs and benefits of
adopting the new investment. Second, the working model provides senior
managers, who might otherwise be skeptical of the projects benefits, with
an opportunity to see and experience what they are buying.

Uncertainty method
The uncertainty method is particularly well suited to situations with highly
uncertain probabilities. While it requires that the individual or group
responsible for the strategic investment decision recognize the likely
monetary outcomes associated with the investment's success or failure, it
does not require an estimate of the probability of success or failure.
There are two main steps to the application of the uncertainty method. In the
first step, the likely monetary effects from the correct and incorrect decision
to adopt the strategic investment and the likely monetary effects from the
correct and incorrect decision not to adopt the investment must be
determined. The inclusion of this latter pair of outcomes ensures that there is
an explicit recognition of the difference between correctly deciding to do
nothing and the mistake of failing to act.
The second step of the uncertainty model involves the selection of a mixture
of optimism-speculation and pessimism-conservatism percentages for the
correct and incorrect outcomes, respectively. These percentages are then
multiplied by the monetary effects that were determined under Step 1. The
decision, either to invest or not invest, is based on which option provides the
highest positive value or the lowest negative value.

Conclusion
Financial performance is one of the key indicators of a firms success and
helps to link strategic goals to performance and provide timely, useful
information to facilitate strategic and operational control decisions. This has
led to the role of finance in the strategic planning process becoming more
relevant than ever.
Empirical studies have shown that a vast majority of corporate strategies fail
during execution. The above financial metrics help firms implement and
monitor their strategies with specific, industry-related, and measurable
financial goals, strengthening the organizations capabilities with hard-toimitate and non-substitutable competencies. They create sustainable

competitive advantages that maximize a firms value, the main objective of

all stakeholders
Words: 2964

References

Strategic Investment Decision-making

http://www.conferenz.co.nz/whitepapers/strategic-investment-decisionmaking

Role of finance
http://gbr.pepperdine.edu/2010/08/the-role-of-finance-in-the-strategicplanning-and-decision-making-process/

Managerial judgement
http://www.cimaglobal.com/Documents/Thought_leadership_docs/cid_r
essum_managerial_judgement_and_strategic_investment_decisions_jun
2008.pdf

Position paper on funds

http://www.futurefund.gov.au/__data/assets/pdf_file/0012/6042/2014_P
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