Chapter 4Chapter 4Investment decision makingInvestment decision making

Learning objectives• explain the key phases and associated information flows

in an investment management process• explain the purpose of a feasibility study and how it

relates to a business case• prepare and analyse a feasibility study• prepare and analyse a business case for a proposed

project• discuss a variety of approaches for project prioritisation• use a range of techniques to help make investment

decisions

• A project is an investment like any other

• The main phases

• of an investment management process are:– Selection of the portfolio– Control of ongoing projects– Evaluation of completed or cancelled projects

Feasibility study• The purpose is to:

– determine if a business opportunity is possible, practical and viable

– provide a structured method:• to focus on problems• identify objectives• evaluate alternatives along with associated benefits and

costs• aid in the selection of the best solution

– improve confidence that the recommended action is the most viable solution to the problem

– assure the sponsor that projects requiring significant resources can, should and will be done.

Business case development

• The purpose of a business case is to:– obtain management commitment and

approval for investment, through a clearly presented rationale

– provide a framework for informed decision making in planning and managing the project and its subsequent benefits realisation.

Business case perspectivesThere are five main perspectives of a business case to

consider in its preparation (OGC, 2003):1. Strategic fit2. Options appraisal3. Achievability4. Commercial aspects5. Affordability

The amount of detail needed in a business case depends to a large extent on the total cost of the project.

Progressive development of a business case

• For large-scale investments, the business case can be developed in progressive stages

• For example, a three-stage process might generate the following components (OGC, 2003):

– Preliminary business case– Outline business case– Full business case

Capital budgeting

• A set of techniques used systematically to evaluate, compare and select projects

• Decisions often have an impact for many years and as such reduce an organisation’s flexibility – an important opportunity cost

Project Appraisals

• The purpose is to assist an organisation in deciding whether a project concept is worth turning into reality

• The following concepts are important when conducting a project appraisal:– Financial vs economic appraisal

– Externalities and their valuation

– Cash flows and sunk costs

– Cash flow analysis

Cash flow analysis

• To establish the value of a project, a financial evaluation is carried out

• Preliminary information required will include: – the evaluation period– project risk– an organisation’s cost of capital– the cost of doing the project

Prioritisation techniques

• Many methods are available for prioritising projects, most of which fall into one of the following categories (Martino, 1995):– financial analysis– decision tree analysis– scoring and ranking– portfolio optimisation– simulation– real options– cognitive modelling– cluster analysis

The prioritisation techniques used should reflect the following considerations:

1. The degree of business risk involved.2. The organisation’s internal and

external environment.3. The corporate governance regime (for

example balance of shareholder versus stakeholder focus).

4. Cost of prioritisation activities compared to expected project returns.