It is impossible to ignore the strategic context in which an investment decision is made. Strategy is concerned with identifying specific oppor- tunities and risks, and is expressed in the strategic evaluation and appraisal of different investment projects. In many cases the evaluation is cursory. Already before any specific appraisal a selection of projects has taken place, sometimes unconsciously. Certain projects are more interesting, meriting consideration within the specific strategic context of the relevant enterprise, or are championed by influential stakehold- ers. Investment projects are dismissed with little attention if they do not fit the general strategic orientation of the enterprise and may be neglected if they have no champion. This is inevitable given the limited ability of decision makers to process all the data available to them.
At its inception an investment is simply an idea, identified in the course of strategic thinking and championed by a particular individual or stakeholder group, a process sometimes referred to as intrapreneur- ship. It becomes a set of evolving constituent elements taking shape as relevant decision makers interpret the environments in which the project is to operate. Just as a strategy is said to emerge, so its con- stituent parts, the various investment projects making up the enter- prise strategy, can also be said to emerge. No investment can be regarded as an off-the-shelf proposal, although for simplicity this is usually taken as the starting point for the process of investment appraisal. In the process of evolution of a project, those developing the project mould the proposal to suit the various environments of oppor- tunity and risk to which the enterprise is exposed. Projects build on existing resources, capabilities and competencies and often add to these new but related assets. Existing competitive advantages act as filtering mechanisms largely determining which projects survive to a point at which appraisal becomes appropriate.
Investments eventually chrystalise as significant commitments of funds, with the prospect of a stream of significant future net returns. In order to properly appraise an investment project the value of the various options and interdependencies should be added to the conven- tional net present value of the project. This gives an expanded form of the net present value formula.
Strategic, or expanded, net present value = Conventional NPV (the intrinsic value) + the value of waiting + RI + UI +/– any allowance for strategic risk
The formula appeared to define a clear decision rule: go ahead if the value of SNPV is positive (remember that whereas NPV, RI and the allowance for strategic risk can be either positive or negative, VW and UI can only be positive, since they can never fall below zero).
The valuation depends on the five variables already indicated: the underlying value of the relevant assets (S); the investment cost (X);
the risk-free interest rate; the cone of uncertainty, often the standard deviation (σ) or variance; and the time to expiry (t). In two articles Luehrman (1998a and 1998b) has shown how it is possible to reduce the number of variables to two option metrics – the value-to-cost metric (S divided by the present value of X) and the volatility metric (σ√ t). If the former is greater than one, it means that the project has a positive conventional net present value. The higher the volatility metric, the more likely it is that a project not currently having a pos- itive net present value will have a positive one in the future. It is possible to map the location of any project on a two dimensional diagram according to the value of the two metrics.
The Investment Process and Decision Making: the Strategic Perspective 93
Lower
Higher
Invest never Invest now
Maybe never Probably later
Volatility Probably never Maybe now
Value-to-cost
0 1.0
Figure 6.1 Mapping an investment strategy
The definition of the boundaries of these regions is arbitrary. Few pro- jects are likely to have a return which justifies immediate investment.
Many are never considered or rejected after a cursory examination.
Those which offer a present value which lies between the two thresh- olds of outright rejection or acceptance, are of greatest interest. Over time, as the years to expiration pass, a project moves in the direction of both a lower value-to-cost metric and a lower volatility metric. The present value of the investment cost rises and the cumulative volatility, or chance of an upside in returns, declines. If it is a project that has never been a project with an ‘invest now’ location the project will tend to finish as an ‘invest never’. This can be countered by two factors, luck – conditions change in favour of the project – or by active manage- ment, that is deliberate action to increase revenues and reduce costs.
The latter is much more important for strategy making, although an ability to ride one’s luck is an important attribute of good strategy making.
Others have collapsed all five variables to one metric, described by Alleman, Suto and Rappoport as the uncertainty-adjusted or risk-nor- malised NPV and referred to in their work as d, a ratio similar to the Sharpe ratio – the net present value, S – X (the first metric), divided by some version of the latter metric, often the standard deviation, σ. It is possible to estimate the ratio which holds when the SNPV = 0, that is when the value of the option equals the negative present value of the project, or rather when it ceases to be negative: this is called D*. A rele- vant comparison can be made between actual d and implied D*. In this case the number of regions on the strategic map is defined as four, rather than six, and the boundaries are unambiguously defined.
There are four possibilities for the decision rule.
NPV is negative and VW either positive or negative, and their aggregate < 0
or d < – D*
Reject the project
This is an obvious case; not much time need be committed to the appraisal.
NPV is negative but VW positive, and their aggregate > 0 or – D* < d < 0
Keep the project alive
The closer to zero the average expected NPV and the greater is its possi- ble variance or standard deviation, the more likely it is that this situa- tion will arise. Much of strategy making is concerned with such projects.
NPV and VW are both positive but NPV < VW or 0 < d < D*
Wait until the value of the option falls below the present value and then invest.
In this case, it will be appropriate to delay the investment. The same arguments apply in this case as in the previous one.
NPV and VW are both positive, but NPV > VW or D* < d
Invest now
This is an obvious case where the project should be undertaken imme- diately. This represents the core area of any strategy, a core which has to be supplemented by marginal projects.
This same picture can be depicted in terms of a difference between what might be called an upper hurdle rate of return beyond which immediate investment is called for and a lower hurdle rate at which complete rejection occurs (Jagannathan and Meier 2002). The size of the difference between the two rates, coined by Jagannathan and Meier – the hurdle premium, indicates the value of waiting. The greater the gap, the more valuable it is to wait. In practice, decision makers use such hurdle rates, well above the discount rate suggested by the CAPM approach. The exact level of the hurdle rate reflects the constraints of managerial and organ- isational capacity within an enterprise and the nature of the project under consideration.
The main problems for strategists are created by the middle two regions in which the conventional net present value is close to zero and there is considerable uncertainty. The third region is particu- larly problematic and more unusual than the second since, in most conditions, investing now in a project with a positive net present value seems an obvious thing to do: it is not. Investment now commits the enterprise to a project which has a real chance of failing, whatever the expected value and distribution of possible The Investment Process and Decision Making: the Strategic Perspective 95
cash flows, or which precludes the exploitation of significant benefits in the next period:
• if there occurs between now and the next period technical changes which must be embodied in new plant and equipment. These benefits would be lost if the investment occurred now, using an old vintage technology. The maturity period must be long to make this a likely event. On the other hand, learning by doing makes no dif- ference to the timing of an investment since it occurs as soon as the investment is made,
• if the total possible output is fixed – there is a limited reserve of some natural resource such as oil or timber involved or some well- located but limited supply of land, and if the price of the relevant output is likely to rise following an increase in demand, it might be beneficial to wait in order to take advantage of the increased price,
• if the period of exploitation of a competitive advantage is fixed by license or patent and delay reduces the period of advantage,
• if the level of risk declines over time and the value of a project rises with a lower rate of discount applied.