Integrated Investing

2.2.1. Payback period

The payback period (PBP) is defined as the period of time in which the invested capital is amortised by the cash inflows of the investment object. The result of the payback period calculation can be expressed in days, weeks, months or years. (Prätsch

et al.

, 2012)

On the one hand, the existence of a payback period itself can already be regarded as an indicator of a profitable investment. Nevertheless, when comparing the relative advantageousness of competing investment objects, the investment object with the shortest payback period indicates the best alternative. This time-based view represents a basic risk assessment, as the near future is perceived as less risky than the distant future. In conclusion, investments with short payback periods express a higher chance of amortising the invested capital than investment objects with long payback periods. (Poggensee, 2011) In addition, quick cash inflows can be re-invested earlier than cash flows occurring in distant future, providing a company financial flexibility, especially in uncertain times.

Due to its simple calculation, the payback period enables quick decision-making. However, Poggensee (2011) argues that it cannot serve as single basis for investment decisions as the payback period does not recognise the lifetime of the investment object. Additional difficulties occur when comparing the payback period of several investment objects with different amounts of capital investment.

A simplified example illustrating this problem can be retrieved in

Table 1

.

Table 1: Simplified example for payback periods of two investment objects

Source: Own example

When comparing the investment objects given in

Table 1

, investment object B shows a better payback period with only one year of amortisation. Hence, the decision-maker would prefer investing in object B, assuming that no additional information is available. However, the expected lifetime of the two investment objects differs widely. Considering the ten years lifetime of investment object A, in contrast to only three years lifetime of investment object B, the decision-maker might invest in object A, since the accumulated profit of investment object A is superior to object B.

2.2.2. Cost comparison and benefit comparison

The two investment appraisal methods comparing costs and benefits are similar to each other, which is the reason for describing them together in this subchapter. As the name already indicates, the focus of the cost comparison method is on the expected costs of the investment objects. Based on these cost projections, the investment objects are compared to each other. Hence, the relative advantageousness can be concluded from the investment object with the lowest amount of costs. Nonetheless, the absolute advantageousness can only be determined in case of replacement or rationalisation investments when comparing the business-as-usual scenario (i.e. opportunity costs of not investing) with the costs of investing into the investment object. (Götze

et al.

, 2008)

The considered expenses comprise operating costs (e.g. for personnel expenses, costs for raw materials, energy, repair and maintenance) as well as financial costs (e.g. depreciation, interest and taxes). The method does not differentiate between fixed and variable costs since all cost accounts of an investment object are accumulated. (Poggensee, 2011)

The cost comparison method bases on the assumption that the revenues and production capacities of the competing investment objects are equal. Since variable costs depend on the planned production capacity, which might be subject to frequent changes, the cost comparison method calculates with the average costs. (Götze

et al.

, 2008) Hence, the cost comparison method ignores the different points of time on which costs and benefits might occur, which therefore classifies as static investment appraisal.

The basic assumptions of similar production capacities and revenue amounts of competing investment objects as well as the ignorance of the time value of money are major points of criticism. Hence, the calculated amounts of costs provide a low likelihood to occur in reality after the investment object has been realised. (Poggensee, 2011)

The benefit comparison method compares the profits of competing investment objects. Hence, the amount of costs as result of the cost comparison method is deducted from the projected revenues of the investment object. Besides this difference, the same assumptions (i.e. identical production capacities and average of variable costs) are applied within the benefit comparison method, concluding the same criticism. (Götze

et al.

, 2008)

With regard to the absolute advantageousness, the investment object should be realised if the profitability is greater than zero. When comparing several investment objects to each other, the relative advantageousness is determined for the investment object with the highest profitability. (ibid.)

2.2.3. Return on Investment

The financial ratio Return on Investment (ROI) determines the profitability of an investment object by calculating the relation of profit and invested capital. The result of the ROI ratio is expressed in a percentage. (Poggensee, 2011)

The ROI ratio is mostly applied on company-level to serve as an indicator of the profitability of the whole company. In this case, the literature refers to the ROI as a profitability ratio pyramid since the nominator and denominator are composed by ratios as well. (Lachnit and Müller, 2012) However, when applied on an investment object, the composition of the ratio is less complex. The ROI, which is also referred to as Accounting Rate of Return (ARR), is determined by the average profit divided by the average invested capital in an investment object (see formula below). While the profit is calculated by the difference between cash inflows and cash outflows over the lifetime of an investment object, the invested capital represents the value necessary to acquire the investment object. (Zimmerman, 2011) Thus, the formula for the ROI can be displayed as follows:

Equation 1: Return on Investment formula for capital investment objects

The expression of the ROI as a percentage enables a conclusion about the efficiency of an investment. If ROI > 0%, the result implicates that the investment is amortised, even without knowing the exact point of time when the investment object amortises. Nevertheless, the decision-maker would decide to invest, since the investment is able to add value to the company’s capital anyway.

When comparing the ROI of several investment objects the investment object with the highest percentage is regarded as the most advantageous. Nonetheless, if there is a minimum percentage value defined for the ROI in companies (e.g. requiring a higher ROI than the costs of capital or the market-based interest rate), the decision-maker might tend towards underinvestment since investment alternatives might not meet the minimum required return rate, especially in high interest market environments.

In contrast to the payback period, the ROI is able to consider the lifetime of an investment object. However, the expected profit in the nominator is calculated by averaging the expected cash inflows and cash outflows of the investment object across its lifetime. Hence, the ROI ignores the fact that an investment object’s profitability might vary over its lifetime. Just as the payback period, the ROI does not consider the time value of money and thus, is referred to as static investment appraisal method.

2.2.4. Net Present Value and Compound Value

The Net Present Value (NPV) considers the time value of money and therefore classifies as dynamic investment appraisal method. From the date of investment, future expected cash inflows and outflows are discounted or compounded via an interest factor to transfer these cash flows to the same point of time (mostly present time as with the NPV). The discounted cash outflows are subtracted from the cash inflows to calculate the net present value. Hence, the result of the NPV calculation is expressed in absolute monetary value. (Poggensee, 2011)

Figure 11

 illustrates the calculation of the NPV:

Figure 11: Illustration of the Net Present Value calculation

Source: Based on Prätsch et al., 2012:347

In case NPV > 0, the decision-maker would decide to invest since the investment object is able to add value to the company. In addition, the investment decision is perceived as less risky since the NPV tries to sketch reality by considering the time value of money in form of the discount factor. Furthermore, the cash flows of the whole lifetime of the investment object are taken into consideration.

However, the decision-maker might tend to overinvest when deciding to invest in each investment object with a positive NPV. That is why the NPV does not reveal any information about the relation between the investment need and the generated profit such as the ROI. Nevertheless, the decision-maker is able to compare several investment objects with the help of the NPV. In this case, the investment object with the highest NPV is regarded as the most profitable over its lifetime.

The Compound Value method (CV) is similar to the NPV. Both methods are classified as dynamic investment appraisal methods by recognising the time value of money. Nonetheless, the biggest difference between these two methods is the point of time future cash flows are transferred to. While the NPV calculates the added value of future cash flows at the starting point of the investment, the CV focuses on the end point of the investment object’s lifetime. While the NPV therefore makes use of a discount factor, the element transferring cash flows to the end point of the investment object’s lifetime is the compound factor. Nevertheless, both factors base on an interest rate which is mostly based on the weighted average cost of capital or market-based interest rates. (Poggensee, 2011; Götze

et al.

, 2008)

The underlying decision criterion with the CV is the same as with the NPV. Hence, absolute advantageousness is given with an investment object showing a CV > 0 while relative advantageousness is assigned to the investment object with the highest CV.

The following figure illustrates the calculation of the CV:

Figure 12: Illustration of the Compound Value calculation

Source: Based on Prätsch et al., 2012:344

2.2.5. Internal Rate of Return

The internal rate of return (IRR) is the discount factor leading to a NPV of zero. While a discount rate for the NPV calculation is based on general assumptions, the IRR calculates the effective discount rate leading to NPV = 0. Hence, it sets the relation of the investment and the future discounted cash flows and thus, provides an indicator of the efficiency and quality of an investment. In addition, the IRR recognises the time value of money and therefore classifies as dynamic investment appraisal. (McLaney, 2009)

To derive the relative advantageousness of several investment objects, the investment object with the highest IRR is preferred. However, in case of no competing investment objects, the decision-maker would decide to invest if the IRR is higher than the costs of capital or the market-based interest rate. This decision is made on the premise that more value can be added to the company’s value by the investment object than with a financial investment on the capital market. (Poggensee, 2011)

The calculation of the IRR is complicated since it is mostly derived by trial-and-error. Furthermore, the IRR leads to unrealistic return rates in some constellations (Zimmerman, 2011). Investment objects with cash flows changing from positive cash flows in one year to negative cash flows in the concluding year even reveal more than one IRR. In this case, it is difficult for the management accounting professional to determine the correct value for the IRR as a basis for decision-making.

2.2.6. Utility Value Analysis

The discussed methods within the previous subchapters can either be classified as a static or a dynamic investment appraisal method and support single quantitative strategic goals. However, in case of multiple quantitative strategic goals or in case of qualitative goals, these investment appraisal methods do not offer a helpful result (compare

Figure 10

).

Hence, the corresponding investment appraisal methods in these cases must be derived from the group of Multiple Attribute Decision-Making (MADM) methods. The most popular method of this group is the Utility Value Analysis which is therefore in the scope of this thesis (Götze

et al.

, 2008).

The Utility Value Analysis (UVA) intends to calculate a value that consists of a weighted sum of several sub-goals. When conducting the UVA, the first step is to determine the sub-goals under consideration. These sub-goals might comprise various quantitative goals (e.g. NPV, ROI, IRR, etc.), a combination of quantitative and qualitative goals or solely qualitative goals. The second step within the Utility Value Analysis assigns weightings to the sub-goals. Each sub-goal is assigned with a relative importance (step two) so that the sum of all weighted sub-goals is equal to 1 or 100. (Poggensee, 2011; Götze

et al.

, 2008)

Afterwards, the third step comprises a judgement of how far each investment object meets each sub-goal. This judgement can either be conducted on basis of a nominal, ordinal or cardinal scale. These assigned values of the expert judgements are multiplied with the weightings of the sub-goals in the following step (step four) to derive a utility value for each sub-goal. (ibid.)

Finally, the utility values of the sub-goals are added to calculate the overall utility value of each investment object (step five). Hence, unfavourable results of one sub-goal can be compensated by favourable results of other sub-goals unless no minimum value was previously determined functioning as a threshold value. (ibid.)

A generic example of the underlying calculations of a UVA can be retrieved from the following table:

Figure 13: Generic example of Utility Value Analysis

Regarding the investment decision, the absolute advantageousness is given if an investment object is above a targeted utility value. Alternatively, the relative advantageousness is given for the investment object with the highest utility value compared to its competing alternatives. (Götze

et al.

, 2008)

As already indicated the UVA experiences increased popularity within business practice. One reason is the fact that the result in form of a single-score value is easily comprehensible. In addition, the method offers a structured procedure and its underlying simple calculations can be conducted also by non-financial experts. (ibid.)

However, the UVA also faces criticism which mainly focuses on the subjective judgements of the person conducting the method. Besides these judgements, the determination of sub-goals and assignment of weightings to these sub-goals represent subjective steps. The steps of weighting the sub-goals as well as the judgement of the utility values require extensive timely effort. Furthermore, the resulting utility values are accompanied with uncertainty, which is why sensitivity analyses should be conducted to assess the degree of deviation of results, in case assumptions, weightings or judgements change. (Poggensee, 2011)

2.3. Modifications of conventional investment appraisal methods

Before describing the literature on environmental investment appraisal methods, the definition of environmental investments needs to be discussed. Günther (2008) defines environmental investments as all investments providing an ecological relevance. In addition, the author states that environmental investments can either be enforced by legislation or implemented voluntarily. Furthermore, environmental investments might comprise either investments in assets for environmental protection or investments extending, substituting or increasing the efficiency of already existing assets. (ibid.) As a consequence, this broad definition can be applied on the majority of regular investments since there is hardly any asset that does not have an ecological relevance.

Baumast (2009) defines environmental investments as the acquisition of assets for the purpose of protecting the environment. Hence, environmental investment appraisal methods assess the profitability of environment protection investments. In addition, Baumast (2009) refers to the option of the ex-post analysis of environmental investment appraisals to analyse the profitability of past environmental protection investments. On the one hand, this definition narrows down the scope by focusing on assets with the aim of environmental protection rather than all investments with an ecological relevance. On the other hand, this definition concentrates on assessing the profitability of these environmental protection investments. However, the environmental impact of the investment objects is neglected in this definition.

The third definition in this context focuses on the integration of economic and ecological considerations in the investment decisions. Assuming a given strategic environmental goal of a company, Isensee and Michel (2011) state that environmental investments have to contribute to this goal. Hence, the environmental impact of the investment object needs to be quantified and integrated into the calculation of the economic advantageousness. This, in turn, enables the decision-maker to choose the optimal investment object contributing to the environmental and financial goals of the company.

In context of this thesis, the definition of environmental investments is a mixture of the three previously discussed positions. The definition can be separated into two parts. While one part deals with the purpose of the investment object, the other part focuses on the intention of analysis.

With regard to the purpose of the investment object, narrowing down the scope of analysis on assets for environmental protection would represent a too narrow limitation, since other assets also provide a significant environmental impact.

Hence, also investments with the purpose of substituting or