Investment analysis is arguably the most important part of corporate financial analysis. In this chapter, we have defined the scope of investment analysis, and examined a range of investment analysis techniques, ranging from accounting rate of return measures, such as return of equity and return on assets, to discounted cash flow techniques, such as net present value and internal rate of return. In general, it can be argued that:

• Any decision that requires the use of resources is an investment decision; thus, investment decisions cover everything from broad strategic decisions at one extreme to decisions on how much inventory to carry at the other.

• There are two basic approaches to investment analysis; in the equity approach, the returns to equity investors from a project are measured against the cost of equity to decide on whether to take a project; in the firm approach, the returns to all investors in the firm are measured against the cost of capital to arrive at the same judgment.

• Accounting rate of return measures, such as return on equity or return on capital, generally work better for projects that have large initial investments, earnings that are roughly equal to the cash flows, and level earnings over time. For most projects, accounting returns will increase over time, as the book value of the assets is depreciated.

• Payback, which looks at how quickly a project returns its initial investment in nominal cash flow terms, is a useful secondary measure of project performance or a measure of risk, but it is not a very effective primary technique because it does not consider cash flows after the initial investment is recouped.

• Discounted cash flow methods provide the best measures of true returns on projects because they are based upon cashflows and consider the time value of money.

• Among discounted cash flow methods, net present value provides an un-scaled measure while internal rate of return provides a scaled measure of project performance. Both methods require the same information, and, for the most part, they agree when used to analyze independent projects. The internal rate of return does tend to overstate the return on good projects because it assumes that intermediate cash flows get reinvested at the internal rate of return. When analyzing mutually exclusive projects, the internal rate of return is biased towards smaller projects and may be the more appropriate decision rule for firms that have capital constraints.

• Firms seem much more inclined to use internal rate of return than net present value as a investment analysis tool; this can be partly attributed to fact that IRR is a scaled measure of return, and partly to capital rationing constraints firms may face.

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