Chapter 4:

Making Capital Investment

Decisions
Manajemen Keuangan Bisnis
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Kelompok 2
24.D3.0002 - Muhamad Sandy Saputra
24.D3.0004 - Putri Dwinta Bramesti
24.D3.0010 - Gita Maria Magdalena
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What You’ll Learn

1. Why do investment decisions matter?

To get why it is important to make smart investment choices

2. The Four Investment Evaluation Methods

Learn about the main ways to evaluate investments in the real word

3. How to use these methods

Understand how to apply each methods to decide if an investment is worth it

4. Steps in making an investment decision

Walk through the key steps to making a solid investment decision

Why does time matter in investment?

1. Investments involve spending money (or other resources) now, expecting to earn a
return later.

2. Usually starts with a large cost upfront

3. Benefits might come after the initial investment (a long wait)

Analogical for a long-term investments:

Building a rice farm

We will need to start everything from the beginning.

- Starting a rice farm by buying the land, seed, equipment

- Plant the seeds and work on the arm for months
- After waiting & nurturing the corps, finally harvest the rice
and start selling it.
- After each harvest (2-3 times a year) in tropical climates like
Indonesia, farmers can start seeing returns.
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Investment Appraisal Methods

Essential part of making decisions in investment is by screening the investment proposals.

The Four-Methods used by business to evaluate investment opportunity:

1. Accounting Rate of Return (ARR)

2. Payback Period (PP)
3. Net Present Value (NPV)
4. Internal Rate of Return (IRR)

Methods Explanation
1. Accounting Rate of Return (ARR)

As a way of measuring a return on investment, it is called ARR because it uses net

income & compares the net income to the cost of an investment.

This method takes the average annual operating profit that the investment will
generate and expresses it as a percentage of the average investment made over the
life of the investment project.

Example:
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Calculation:
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2. Payback Period (PP)

This is the time taken for an initial investment to be repaid out of the net cash
inflows from a project.

● The shorter the payback time

● Analyze the cash flow
● Pay attention to break-even point

Example:

Calculation:

The project has gained the cash flows into positive, it reflects on how the two and three
years’ time works. We can see that the cumulative cash flows become positive at the end of
the third year.

Thus, if we assume that cash flows occur at the year-ends, the investment will take three
years for the initial outlay to be paid back.

If, however, we assume that cash flows occur evenly over the year, the payback period will
be:
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3. Net Present Value (NPV)

Is a method for determining the present value of each cash flow (inflow or outflow),
discounted at the project’s cost of capital.

● considers all of the cash flows for each investment opportunity, and
● makes a logical allowance for the timing of those cash flows.

Example:

Calculation:

*Discount rate = 20%

Year-by-year calculation
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If we conclude the calculation, it will be as follows:

In this case,
The NPV is positive - £24,190, so the project should go ahead by accepting the
project and buying the machine.
The business can ‘buy’ these benefits for just £100,000 today.
By investing in the machine the project will make £24,190.

4. Internal Rate of Return (IRR)

Is the discount rate that, when applied to its future cash flows, will produce an NPV
of precisely zero.
When the project discounted the cash flows of machine project at 20%,
we found that the NPV was a positive figure of £24,190 (see p. 165).

The higher the discount rate, the lower will be the NPV.
This is because a higher discount rate gives a lower discounted figure.
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Investment Appraisal and Strategic Planning

Investment Appraisal
Investment appraisal refers to the evaluation of investment opportunities to
determine their viability and potential to generate returns. Key methods of
investment appraisal include:
· Net Present Value (NPV):
· This method calculates the difference between the present value of cash
inflows and outflows over a period. A positive NPV indicates a profitable
investment.
· Formula: NPV=∑Ct(1+r)t−C0NPV = \sum \frac{C_t}{(1 + r)^t} -
C_0NPV=∑(1+r)tCt−C0 Where:
o CtC_tCt = Cash inflow at time ttt
o rrr = Discount rate
o ttt = Time period
o C0C_0C0 = Initial investment
· Internal Rate of Return (IRR):
· IRR is the discount rate that makes the NPV of an investment zero. It reflects
the project's expected return. The higher the IRR, the more attractive the
investment.
· Payback Period:
· This method measures how long it will take to recover the initial investment
from the cash flows generated by the project.
· Simple but ignores the time value of money and cash flows after the
payback period.
· Profitability Index (PI):
· PI measures the ratio of the present value of future cash flows to the initial
investment.
· Formula: PI=PV of future cash inflowsInitial investmentPI = \frac{PV \, of \,
future \, cash \, inflows}{Initial \,
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investment}PI=InitialinvestmentPVoffuturecashinflows A PI > 1 indicates a

potentially profitable project.
· Accounting Rate of Return (ARR):
· ARR measures the expected profitability of an investment, usually by
dividing average annual profit by the initial investment.
· Sensitivity Analysis:
· This is used to test how sensitive a project’s outcomes are to changes in key
assumptions, such as costs, revenues, and discount rates.

Strategic Planning
Strategic planning is the process of defining an organization’s strategy or direction
and making decisions on how to allocate resources to pursue this strategy. It
typically involves setting long-term objectives, analyzing competitive environments,
and determining how to achieve goals sustainably. Key aspects include:
1. Vision and Mission:
o The organization sets out a long-term vision and a mission statement
that aligns with its core values and purpose.
2. Environmental Analysis (SWOT, PEST):
o SWOT Analysis: Identifies an organization’s strengths, weaknesses,
opportunities, and threats.
o PEST Analysis: Analyzes political, economic, social, and technological
factors that may impact the organization.
3. Setting Objectives:
o SMART goals (Specific, Measurable, Achievable, Relevant, Time-
bound) are created to align with the organization’s mission.
4. Strategy Formulation:
o This is where investment decisions are linked. Organizations decide
on strategic initiatives that align with their financial and operational
goals, such as market expansion, innovation, or mergers.
5. Resource Allocation:
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o Resources (financial, human, technological) are allocated based on

strategic priorities. Investment appraisal helps to prioritize projects
that offer the best returns aligned with the strategy.

6. Risk Management:
o Strategic planning incorporates risk assessments to identify potential
challenges and opportunities that could impact the organization’s
objectives.
7. Monitoring and Control:
o The strategic plan is continuously monitored to ensure that
objectives are being met. Adjustments are made based on
performance indicators and changing market conditions.

Connection between Investment Appraisal and Strategic Planning:

· Investment appraisal ensures that the resources are used efficiently, aligned
with the broader strategic objectives.
· Projects with positive appraisals contribute to achieving the long-term goals
set out in the strategic plan.
· Strategic planning provides the framework within which investment
decisions are made, ensuring that investments are consistent with the
company’s vision and objectives.

These two processes ensure that organizations make well-rounded decisions that
balance short-term returns with long-term growth and sustainability.
The best investment projects are usually those that match the business’s internal strengths
(for example, skills, experience, access to finance) with the opportunities available. In areas
where this match does not exist, other businesses, for which the match does exist, will
have a competitive advantage. This means that they will be able to provide the product or
service at a better price and/or quality.
Real World 4.8 describes how the Walt Disney Company, the entertainment business, made
an investment in 21st Century Fox, the media business. Disney’s management believed that
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this represented a good deal. for another purchaser, paying the same price, for whom
there was not such a high degree of strategic fit

Fox is a good fit Disney chief executive Robert Iger reached his original $52.4 billion deal
with Mr Murdoch (founder of 21st Century Fox) in December. But Mr Iger said he was
certain the new price was worth paying even though, once Fox’s nearly $14 billion of
outstanding debt is included, its overall value would be $85.1 billion, making it one of the
largest media takeovers on record. ‘After six months of integration planning we’re even
more enthusiastic and confi dent in the strategic fit

The investment Appraisal Process

The investment appraisal process is a structured method used by businesses to evaluate
potential investment projects to ensure optimal use of funds and identify the most
profitable projects, this process consists of several main steps, namely:

1. Determining the available investment funds, namely the first step is to identify
the amount of funds that can be used for investment which is influenced by internal
factors or management beliefs and external or market conditions, in situations of
limited funds, priority should be given to the most profitable projects by optimizing
the use of limited capital
2. Identifying profitable project opportunities, once funds are determined, the
company must look for investment opportunities such as new product
development, service improvements or investments in efficiency. This process must
be aligned with the company's strategy and requires in-depth information gathering
3. Refine and classify the proposed projects, promising ideas should be drafted into
formal proposals. Projects are classified by objectives, such as new product
development, service improvement, cost reduction or regulatory requirements, with
this classification helping to evaluate risks and information needs
4. Evaluating the proposals, the projects that have been screened are then evaluated
in depth including objectives, alignment with the company's strategy, costs, cash
flows and associated risks. Evaluation uses techniques such as NPV or net present
value to compare competing projects using premortem approaches that are used to
identify potential project failures and risks
5. Approve the project, after evaluation, a decision is made whether or not the
project is approved. Large projects may require approval from a superior, while
small projects may be authorized by lower-level managers. The impact of rejecting
the project must also be considered
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6. Monitor and control the project, once the project is underway, progress must be
monitored to ensure cash flows are in line with estimates and objectives are being
achieved. If there is a significant deviation then corrective action will be taken. Post-
completion audits are conducted to assess project performance and learn from
experience, although these audits can trigger managers' fear of taking risks.

INVESTMENT DECISIONS AND HUMAN BEHAVIOR

investment decisions and human behavior, highlighting the key concepts and
biases involved.

Behavioral Finance: The Human Side of Investment Decisions

Behavioral finance addresses the impact of psychology on financial decisions,
offering insights into why investors make seemingly irrational choices. Here are the
key cognitive biases and emotional influences that affect investment decisions:

1. Overconfidence Bias
· What it is: Investors overestimate their knowledge, skills, and ability to predict
market movements.
· Effect on investment: Overconfident investors may take excessive risks, trade too
frequently, or over-invest in specific assets, often leading to suboptimal
outcomes. They might believe they can "time the market" better than they
actually can.

2. Herding Behavior
· What it is: Investors follow the actions of the majority or a "herd" rather than
making independent decisions based on their own analysis.
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· Effect on investment: This can lead to market bubbles or crashes. Investors may
buy into overvalued stocks during a market rally or sell in a panic during
downturns, amplifying market volatility.

3. Loss Aversion (Prospect Theory)

· What it is: Investors feel the pain of losses more intensely than the pleasure of
equivalent gains.
· Effect on investment: Investors might hold onto losing stocks for too long to
avoid realizing a loss (hoping they will rebound) or sell winning stocks too early
to lock in gains. This can lead to poor portfolio performance.

4. Anchoring Bias
· What it is: Investors rely too heavily on the first piece of information they receive
(the “anchor”), such as an initial stock price or earnings forecast.
· Effect on investment: Investors may fail to adjust their views in response to new
information, leading to misjudged investments based on outdated or irrelevant
data.

5. Confirmation Bias
· What it is: Investors seek out information that confirms their existing beliefs or
opinions, while ignoring contradictory evidence.
· Effect on investment: This leads to reinforcing poor investment decisions. For
example, an investor bullish on a stock might only focus on positive news and
dismiss negative signals, leading to a potential overexposure to risky assets.

6. Familiarity Bias
· What it is: Investors tend to prefer investments they are familiar with, such as
companies or industries they know well.
· Effect on investment: This results in a lack of diversification. Investors may over-
invest in domestic stocks or familiar industries, exposing them to sector or
regional risks.

7. Recency Bias
· What it is: Investors give more weight to recent events or trends, assuming they
will continue in the future.
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· Effect on investment: During a bull market, investors may believe the market will
continue to rise indefinitely and take on more risk. Conversely, in a bear market,
they may become overly pessimistic, selling assets at a loss.

8. Mental Accounting
· What it is: Investors treat money differently depending on where it comes from or
how it is labeled.
· Effect on investment: An investor might take more risks with a bonus or
unexpected gain while being more conservative with savings. This segmentation
can lead to irrational decision-making and inconsistent risk-taking.

9. Regret Aversion
· What it is: Investors avoid making decisions because they fear making a wrong
choice and feeling regret.
· Effect on investment: Regret aversion can lead to inaction or "paralysis by
analysis." Investors may fail to invest in promising opportunities due to the fear
of losing money, potentially missing out on gains.

10. Disposition Effect

· What it is: Investors are inclined to sell assets that have increased in value too
soon and hold onto assets that have decreased in value for too long.
· Effect on investment: This behavior, driven by the desire to "lock in gains" and
avoid realizing losses, can lead to an unbalanced portfolio and missed
opportunities for higher returns.

Impact on Investment Strategy

Human behavior and biases can lead to common investment mistakes. To mitigate
these effects, investors can adopt strategies such as:
1. Diversification: Reducing reliance on individual stocks or sectors by
spreading investments across different asset classes, industries, and
regions.
2. Setting Long-Term Goals: A clear, long-term strategy helps reduce
emotional responses to short-term market fluctuations.
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3. Automated Investing: Utilizing automatic investment plans or robo-

advisors can reduce the emotional influence on decision-making by
sticking to a predetermined strategy.
4. Regular Rebalancing: Rebalancing a portfolio periodically ensures that it
remains aligned with the investor’s risk tolerance and objectives,
counteracting biases like recency and overconfidence.
5. Behavioral Awareness: Simply being aware of one’s cognitive biases can
help mitigate their impact. Investors can seek advice or adopt decision-
making frameworks that involve objective analysis rather than relying
solely on intuition.

The sequence of stages described earlier may give the impression

that investment decision making is an entirely rational process.
The citation you've provided refers to a study by Hasan, M. (2013) on the capital
budgeting techniques used by small manufacturing companies, published in the
Journal of Service Science and Management. Here's a brief overview of what this type
of study typically examines:

Overview of the Study:

In this paper, Hasan (2013) likely discusses the capital budgeting techniques
commonly used by small manufacturing firms and explores how these firms
evaluate their investment opportunities, manage financial risks, and make long-
term capital investment decisions. Capital budgeting is crucial for manufacturing
companies as they often deal with significant investments in equipment,
technology, and infrastructure.

Key Points Likely Covered in the Study:

1. Common Capital Budgeting Techniques:
o Payback Period: One of the simplest and most widely used methods
in small firms, as it focuses on how quickly an investment will
return the initial cost.
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o Net Present Value (NPV): Discusses whether small manufacturing

firms are using NPV and how they account for the time value of
money in decision-making.
o Internal Rate of Return (IRR): Another widely accepted method in
larger corporations, and its adaptation in smaller companies.
o Profitability Index: An indicator of how profitable a project is
relative to its investment.
2. Constraints Faced by Small Companies:
o Limited Access to Resources: Small manufacturing firms often face
resource constraints and may rely on simpler, less sophisticated
techniques.
o Risk and Uncertainty: The study might have explored how these
companies handle uncertainty and risk in their budgeting decisions,
including the use of sensitivity analysis or scenario planning.
3. Practical Application:
o The study likely includes real-world case studies or data on the
budgeting processes used by smaller manufacturers, illustrating
how these companies decide which projects to undertake.
4. Findings and Recommendations:
o Hasan may have found that many small manufacturing companies
favor simpler techniques like the payback period due to ease of
understanding and resource limitations, even though more
advanced techniques like NPV or IRR might offer better long-term
financial insight.

In Corporate Finance and Investment (Pike, Neale, and Akbar, 2018), investment
decisions are influenced not only by financial models and market conditions but
also by human behavior, which can sometimes deviate from rational financial
decision-making. Here’s a breakdown of the key ideas surrounding investment
decisions and human behavior:

1. Traditional Investment Decision-Making

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In classical finance theory, investment decisions are typically made based on:
· Net Present Value (NPV): Investors should pursue projects with positive
NPV, where expected future cash flows exceed the initial investment.
· Internal Rate of Return (IRR): Projects with an IRR greater than the cost of
capital should be accepted.
· Risk-Return Tradeoff: Investors balance risk with expected return, typically
choosing investments with higher returns for a given level of risk.
Traditional approaches assume that investors are rational, meaning they make
decisions that maximize their wealth by assessing available information and
acting logically.

2. Behavioral Finance
In practice, human behavior often deviates from the rational decision-making
assumed by traditional financial theories. Behavioral finance highlights the
impact of cognitive biases and emotional factors in investment decisions. Key
concepts include:
● Heuristics: Investors often use mental shortcuts or "rules of thumb"
to make complex decisions more manageable. While heuristics can be
helpful, they may lead to systematic errors in judgment.
o Example: Investors might rely on past stock performance as an
indicator of future success, even though it's not a guarantee.
● Overconfidence Bias: Investors may overestimate their ability to
predict market movements or pick successful investments. This can
lead to excessive trading or risk-taking, often resulting in lower returns
than expected.
● Loss Aversion: Investors tend to be more sensitive to losses than to
equivalent gains, a concept from prospect theory. This means they
may avoid selling losing investments (hoping for a rebound) or be
hesitant to invest in riskier projects, even if the expected return is high.
● Anchoring: Investors may become "anchored" to specific price points
or historical benchmarks, which can distort their investment decisions.
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For example, they might focus too much on the purchase price of an
asset, influencing whether they hold or sell it.
● Herd Behavior: Investors often follow the actions of others, leading to
herd-like behavior. This can create asset bubbles (when prices rise
beyond the asset’s intrinsic value) or market crashes (when everyone
sells at the same time).
● Mental Accounting: Investors sometimes treat money differently
based on its source or intended use. For example, they might be more
willing to take risks with "found money" (like a bonus) than with their
regular income, even though the source of the funds should not
matter in rational decision-making.

3. Impact of Emotions on Investment Decisions

Emotions, such as fear and greed, can significantly impact investment decisions.
For instance:
· Fear can lead to excessive caution, causing investors to miss out on
profitable opportunities or sell assets prematurely during market
downturns.
· Greed may drive investors to take excessive risks, leading to speculative
bubbles or poorly considered investments.
Emotional decision-making can undermine traditional, rational investment
strategies, leading to suboptimal outcomes.

4. Framing Effects
The way investment choices are framed or presented can influence decision-
making. For example, an investment opportunity described in terms of potential
gains is often more appealing than one described in terms of potential losses,
even if the underlying risk and return profile is the same.

5. Market Inefficiencies and Behavioral Anomalies

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Behavioral biases can cause market inefficiencies, where asset prices deviate from
their true intrinsic value. Examples of these inefficiencies include:
● Stock Market Bubbles: When irrational exuberance leads to unsustainable
price increases, as seen during the dot-com bubble.
● Momentum Effects: Investors may continue buying a stock simply because
its price has been rising, ignoring whether its fundamentals justify the
increase.
● Contrarian Strategies: Some investors attempt to capitalize on behavioral
inefficiencies by adopting a contrarian approach, buying when others are
selling and vice versa.

6. Real-World Application: Behavioral Insights in Corporate Finance

● Corporate Investment Decisions: Managers may also exhibit behavioral
biases, leading to suboptimal investment decisions for the firm.
Overconfidence can lead managers to overestimate the success of projects,
while loss aversion may cause them to avoid risky, yet potentially profitable,
ventures.
● Investment Appraisal: Behavioral factors influence how investment projects
are appraised. Rather than relying solely on objective metrics like NPV or IRR,
personal biases and the desire for short-term results can skew decision-
making.