Why Rigorous Investment Analysis Matters

Rigorous investment analysis means that capital projects will be evaluated in a manner consistent with modern financial concepts by qualified project professionals.

The major decision criterion in modern finance is called net present value analysis. It requires the analyst to make estimates of a number of crucial expenditures and revenue outcomes. These estimates are certainly difficult to make but well versed capital budgeting managers can make reasonable estimates.

The net cash flows are estimated for each period, typically a year, of the investment life. These net cash flows are then discounted to the present at the cost of capital of the entity making the investment. If the present value of the net cash flows exceeds the cost of entering the project then the project creates economic value for the entity and should be undertaken. If the net present value is negative then the project should be rejected.

In addition to net present value analysis, during the last 15 years or so the concept of real options has entered the capital budgeting discussion. Options measure the value of flexibility. Flexibility has value in capital projects because it will allow the manager to cut losses if things do not go well or to augment gains if they do, thereby improving the net present value outcome. Therefore, while still controversial, the value of flexibility should be added to the net present value in judging a project’s viability.

Of course all this analysis does not guarantee success. In fact, we can be quite confident that the numbers derived from the analysis will not be the actual values. The reason is that the world changes in ways that are difficult, if not impossible, to predict. The longer the duration of the project the more surprise events that are likely to occur. However, educated well analyzed projects that predict positive net cash flows should, on average, prove successful and on net add value to the entity conducting the investment.

When enterprises invest in projects that have negative outcomes value is destroyed. Destroying value reduces the wealth base and requires even greater sized positive outcomes to make up for the negative outcomes. In order to have greater sized positive outcomes to make up for losing outcomes, more risk must be undertaken. More risk increases the chances of important failures. Eventually the enterprise can find itself in a declining wealth position.

In the Gulf Region, the government, often through its sovereign wealth fund, is a particularly important provider of capital. It is crucial that capital decisions reflect the welfare needs of the citizen owners of the government. Since the government may wish to invest in socially oriented projects such as healthcare, free park facilities, and education; projects that perhaps garner productivity benefits in the future but are not likely to create positive net cash flow in the short run, the importance of the success of their more market oriented investments rises.

In the final analysis both the present and future generations of the Gulf nations will be well advised to conduct rigorous financial analysis of their portfolio of capital projects. The result will be a brighter economic future.

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