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2. State of current academic knowledge
This chapter represents an introduction to the current academic knowledge of the corresponding issues of this thesis. While the first subchapter highlights the investment process within companies, the second subchapter discusses conventional investment appraisal methods which are commonly used in business practice. The following subchapter analyses environmental modifications of the previously identified investment appraisal methods. Finally, before the final deficit analysis summarises the weaknesses of the discussed methods, the current academic knowledge regarding environmental impact assessments in companies is introduced.
2.1. Investment decisions in companies
2.1.1. Attributes and characteristics of investments in literature
Purpose of investments
According to Poggensee (2011), investment decisions are a critical factor for the success of a company since the invested capital is bound for long time. This in turn restricts the scope of action of a company. Hence, it is important to invest into projects that support the company’s strategy so that strategic goals can be achieved. Therefore, investment decisions describe the direction of the future development of a company (Jasch and Schnitzer, 2002) and thus need to be taken with the intention to support strategic goals of a company.
Hence, the origin of the necessity for investments can be found in the formulation of strategic goals. These goals are typically formulated as financial values such as a targeted return on investment or a targeted net present value which should be added to the company value (Hungenberg, 2012). However, also qualitative goals are formulated such as a top position in an external ranking or a defined amount of patent applications (Gladen, 2011).
Strategy implementation describes the way to achieve these goals. Hence, the task of the product management is to achieve these goals with either existing products or by developing, marketing and selling new products. The underlying strategic marketing decisions are either based on a previous outside-in or inside-out analysis. While the inside-out analysis focuses on the question which products can be developed and sold on which markets with existing resources, the outside-in analysis works with the opposite perspective. Hence, the outside-in perspective starts with an analysis of the target market to derive a product idea to finally identify the internal resources necessary to produce and sell this product (Grünig and Kühn, 2011).
In conclusion, before the investment planning process is started within a company, strategic goals need to be determined and decisions regarding new product development or marketing measures of existing products need to be made. These decisions, in turn, impact on the production facilities of a company. Hence, new plants need to be established or existing plants are extended or adjusted.
The extent to which these measures are examined is limited by the capital budgeting process which runs parallel to these strategic decisions. Therefore, the marketing or sales management has to forecast sales and expected turnover which in turn determines the size of capital budgets, cost budgets and targeted profits. (Zimmerman, 2011)
The subsequent operational strategy implementation begins with comprising amongst others the investment planning process. This process serves to support the strategic goal by identifying the most efficient way of investing. (Grünig and Kühn, 2011)
The following figure provides an overview over the different purposes of investments in companies:
Figure 2 : Characteristics of the investment attribute ‘purpose’
Source: Own illustration based on sources above
Scope of investments
Regarding the scope of investments, the differentiation between single investments and investment programs is vital for the investment process. As described above, the strategic goals of a company influence the investment planning process. In case the achievement of strategic goals requires investing in several mutually non-exclusive investment objects, the assessment of the best combination of these objects is referred to as investment program planning (Becker, 2012).
The scenario in which another department (e.g. sales, marketing, product management, etc.) determines the size of capital budgets is referred to as ‘successive investment program planning’. In contrast to that, the interdependencies and given limitations are recognised and sorted out in close cooperation between both departments with simultaneous programming. (ibid.) The following figure provides an overview of the different scopes of investments in companies:
Figure 3: Characteristics of the investment attribute ‘scope’
Source: Own illustration based on sources above
Process of investments
The investment processes for single investments contains six steps which are iteratively run through. First, the problem situation is formulated pointing towards an investment need. The second phase is characterised by research for investment objects which might be able to solve the previously-described problem situation. The next step comprises the appraisal of competing investment objects. In this phase, the profitability of each investment object is projected and compared to the other investment objects. While the fourth phase is defined by the actual investment decision, the investment object is realised in phase five. Finally, the last phase deals with the ex-post analysis of the originally projected profitability with the actual profitability of the investment object. (Poggensee, 2011; Prätsch et al., 2012) The following figure provides an overview over the different process steps of investments in companies:
Figure 4: Characteristics of the investment attribute ‘process’
Source: Own illustration based on sources above
Focus of investments
Prätsch et al. (2012) differentiate between two perspectives when defining investments. On the one hand, there is a cash flow-focused investment definition. Thus, investments are defined as cash flows which are characterised by outflows at the beginning of an investment with associated cash inflows at later points of time. On the other hand, there is the reporting-focused investment definition which concentrates on the financial localisation of investments within the company’s balance sheet.
Poggensee (2011) also constitutes a lack of consistency in defining investments. He identifies three popular perspectives from which to define investments. One perspective corresponds with Prätsch et al. (2012) in recognising the timing of cash flows as central point of the definition. The second perspective deals with the intention of the investment which is to acquire fixed (tangible or intangible) assets. The third perspective concentrates on the investment appraisal itself and its intention to create a basis of comparison to alternative investment objects. (Poggensee, 2011) The following figure provides an overview of the different focuses of investments in companies:
Figure 5: Characteristics of the investment attribute ‘focus’
Source: Own illustration based on sources above
Ownership of investments
Besides these capital asset-oriented investment definitions, Pape (2011) adds a financial perspective. Hence, investments can also comprise the merger or acquisition of external companies but also the acquisition of financial entities generating profit such as financial derivatives, loans, bonds or securities.
While literature on investments usually assumes the acquisition of an asset, leased assets are also part of this discussion. McLaney (2009) differentiates between operating and finance leases. While operating leases comprise hiring an asset instead of purchasing it, finance leases occur in form of sale and leaseback contracts, in which the user purchases the asset at first place, sales it to a financier in a second step to finally lease it back in order to continue its utilisation. (ibid.) Although the actual ownership is transferred to a third party (financier), the control and operation remains at the user.
The following figure provides an overview over the different ownership options of investments in companies:
Figure 6: Characteristics of the investment attribute ‘ownership’
Source: Own illustration based on sources above
Types of investments
In addition to various definitions of investments, the literature describes three main categories regarding the type of investments. The first category refers to foundational investments to acquire the first property plant and equipment allowing a start-up business to set up its operations. The second category comprises continuous investments for existing plants and equipment, for instance investments preserving production capacity such as renovation or retrofitting of existing plants and equipment. The third category is characterised by complementary investments. On the one hand, this can involve expansion of production capacity by acquiring additional plants or equipment. On the other hand the efficiency of already existing machinery can be increased by rationalisation investments. In addition, this third category also comprises diversification investments necessary, for instance, to meet the trend of mass customisation, for instance. (Prätsch et al., 2012)
Apart from these three main types of investments, the literature highlights two additional terms which roughly summarise the variety of investment categories. On the one hand, there is the term of ‘greenfield investments’ which described the establishment of new facilities from scratch. These new facilities can either serve as foundational investment or as complementary (e.g. for expansion or diversification) investment. On the other hand, there is the term of ‘brownfield investment’ which involves the acquisition of existing facilities. This might be the case for continuous investments or complementary (e.g. rationalisation) investments. (Morschett et al., 2010)
The following figure provides an overview of the different types of investments in companies:
Figure 7: Characteristics of the investment attribute ‘types’
Source: Own illustration based on sources above
Time period of investments
Another important issue regarding relevant specifications is the time period under consideration. The concept of life cycle costs (LCC) sums up all costs associated with an asset along its complete life cycle. Since the term ‘life cycle’ is used by several academic professions, it is important to differentiate between the environmental and economic definition of life cycle. Both professions refer to the term ‘life cycle’ when considering more than just the production and utilisation of a product. However, the biggest difference concerns the focus of the phases before and after production and utilisation.
While the economic life cycle ranges from research and development of the product, over production to marketing (i.e. utilisation of the product from a company’s perspective) and finally removal from the market, the ecological life cycle ranges from resource extraction to production and utilisation of the product to finally end with its disposal.
With regard to the activities prior to production, the environmental life cycle perspective considers all activities necessary to extract and process the resources needed to manufacture the product. In contrast to that, the economic life cycle perspective considers research and development activities as relevant step prior to production. Also the phases after the production and utilisation differentiate between both perspectives. While the economic perspective assumes the end of manufacturing and marketing activities of the product, the environmental perspective focuses on the disposal of the product and its impact on the environment.
According to Schebek (in Ausberg et al., 2015), both perspectives influence each other. In order to generate an environmental impact in form of resource extraction, a product first needs to be developed. During production and utilisation, the product consumes resources and causes emissions impacting on the environment. Finally, when it is not economically viable to manufacture and market the product, the impact decreases. However, at the end of the functional life cycles of the products, the disposal causes additional impacts on the environment. Hence, environmental impacts are connected to market mechanisms such as economic life cycles. (ibid.)
When discussing the concept of LCC, the economic perspective of the life cycle is assumed as underlying basis. Ideally, the costs of an asset are recorded in the different phases which are structured into research and development, production and construction, operation and support as well as dismantling and disposal of an asset (Lichtenvord et al., 2008). While conventional economic concepts of LCC focus on all associated direct and indirect costs, environmental LCC studies complement these data with corresponding external costs (i.e. environmental impacts from resource consumption and emissions) which should be internalised to represent all relevant costs (ibid.).
Nevertheless, the existence of various actors involved in the life cycle of an asset creates the problem of who should bare which costs. Especially, since the costs of one actor might be the revenues of another actor. Therefore, the term of total cost of ownership (TCO) narrows down the scope and time period of recorded costs. As Thiede et al. (2012:275) claim: “TCO subsumes all cost proportions that occur for the operator of a machine”. Examples for these subsumed costs may involve “acquisition, installation, training, energy, maintenance, planned or unplanned downtime and disposal” (ibid.:276). Additional costs under consideration might involve costs of capital and depreciation.
The following figure provides an overview over the periods of time under consideration of investments in companies:
Figure 8: Characteristics of the investment attribute ‘time period’
Source: Own illustration based on sources above
The various attributes and their corresponding characteristics which are discussed in the literature addressing investments are summarised in the following figure:
Figure 9: Overview of attributes of investments as described in literature
Source: Own illustration based on sources above
2.1.2. Attributes and characteristics of investments in context of this thesis
Since there is a huge variety of characteristics and no consistent definition of investments, it is necessary to determine the attributes and characteristics of investments for the context of this thesis.
Regarding the purposes of investments, this thesis focuses on the aim to support the achievement of strategic goals of a company, since the alternative strategy implementation does not necessarily involve investment decisions. In addition, the investment appraisals in today’s business practice are expressed along the quantified strategic goals of a company. Hence, decision-makers aim to support strategic goals of a company with their investment decisions.
The scopes of investments differentiate between investment programs and single investments. Since the sum of single investments form an investment program, the scope focuses on assessing single investments in context of this thesis.
Regarding the processes, this thesis discusses the implications of the complete investment process, ranging from investment planning, over its decision to the investment realisation. This decision is taken based on the various opportunities the complete process offers for the integrated investing method to adjust and extend existing investment practice in companies.
Concerning the focuses, the cash flow-based definition is considered as result of systematic exclusion. While the investment appraisal-based definition highlights only one phase of the investment process, the reporting-based definition is concerned about the localisation of investments in the balance sheet. This localisation, however, does not offer enough level of detail since it sums up each investment value in one aggregated figure at only one point of time within a balance sheet.
The ownership attribute differentiates between acquisition and leasing fixed assets. Due to the cash flow-based definition of investments, which recognise an initial cash outflow at the beginning of ownership of the fixed tangible-assets, leasing is not considered to be part of this thesis. In addition, the literature discusses leasing options as part of corporate financing which is also not covered by this thesis. Since the acquisition of intangible assets and financial assets do not necessarily involve an environmental impact, the acquisition of fixed tangible assets is part of the characteristics in context of this thesis.
Furthermore, the literature differentiates between several types such as greenfield and brownfield investments. The existence of environmental impacts is the reason behind the choice of investment types. As a consequence, greenfield investments as well as brownfield investments are considered within further research and discussion.
With regard to the time period under consideration, the ownership of the fixed tangible asset is considered from the operator’s view, which includes the phases described within the TCO-approach (i.e. construction, operation and support as well as dismantling and disposal).
Definition of investments in context of this thesis
Investments are defined as single investments in form of cash outflows enabling to acquire fixed tangible assets for greenfield or brownfield sites, which generate (imputed) cash inflows over the time of the operator’s ownership, aiming to eventually help a company in achieving its strategic goals.
Hence, cash outflows in form of direct and indirect costs (and also imputed cash inflows in form of avoided costs) are considered as long as the investment object is owned and controlled by the company.
The following figure summarises the definition of investments used in context of this thesis.
Figure 9: Attributes and characteristics of investments in context of this thesis
Source: Own illustration based on sources above
2.2. Conventional investment appraisal methods
Investment decision vs. investment appraisal
The literature often suggests that the result of the investment appraisal already implies the investment decision. However, Prätsch et al. (2012) argue for a strict separation between investment appraisal and investment decision as the people involved within these two phases are separate persons. While management accounting professionals are responsible for the calculation of the investment appraisal, the executive management is responsible for making the investment decision (ibid.).
Poggensee (2011) also argues for a strict separation since investment appraisal methods work with simplified models trying to express reality in quantitative values. This representation of reality involves a reduction of complexity with the help of assumptions. Nevertheless, the decision-maker has to consider also non-monetary and qualitative criteria to make a comprehensive investment decision.
Another argument can be seen in the different objectives of the two phases. On the one hand, the investment appraisal intends to create a quantitative value for each investment object. The quantitative values of the competing investment objects can be compared to each other to determine their relative advantageousness. On the other hand, the investment decision aims for an improvement of the current state of the company. This improvement is achieved by adding value to the company value through the returns or saved operating expenses caused by the investment object. Hence, investments aim to enable the company in achieving its strategic goals. (ibid.)
Classification of investment appraisal methods
The classification of investment appraisal methods depends on the formulation of strategic goals which the methods intend to support. Hence, the first step is to distinguish between quantitative and qualitative strategic goals. Furthermore, the second step is to clarify whether investment appraisal methods have to support one strategic goal or whether there are several goals that have to be achieved equally. The third step comprises a differentiation between single independent investments and an investment program in which several investments depend on each other. (Poggensee, 2011)
Figure 10 provides an overview of the classification of strategic goals and the corresponding investment appraisal methods.
Figure 10: Classification of strategic goals and corresponding investment appraisal methods
Source: According to Poggensee, 2011
While static investment appraisal methods mostly concentrate on the profitability and payback period of an investment, dynamic investment appraisals recognise the points of time of cash inflows and outflows. Hence, dynamic investment appraisal methods include interest rates to calculate the net present value of an investment or the internal rate of return. Dynamic investment appraisal methods are perceived as superior to static investment appraisal methods since the recognition of the time value of money enables the calculation to produce more realistic results. (Jasch and Schnitzer, 2002)
Although static investment appraisal methods do not qualify as the only basis of investment decisions, since they lack recognising the time value of money, they are still commonly used in companies (Poggensee, 2011). One reason for this contradiction can be seen in the simple calculation enabling a quick application and rough orientation. Hence, the most common static investment appraisal methods (i.e. return on investment, payback period, cost or benefit comparison) are discussed in this thesis as well.
Risk and uncertainty in investment appraisal methods
Other important aspects when discussing investment appraisal methods are the issues of risk and uncertainty. While risk is commonly stated as the damage impact multiplied by the probability of occurrence of a negative event, uncertainty deals with the lack of knowledge about the consequences of the investment as well as uncertainty about the data quality level. (Poggensee, 2011)
However, risk management and also uncertainty originating from a low level of data quality are not in the focus of this thesis. Hence, the premise is given that the person calculating the investment appraisal retrieves data and also considers relevant risks in all conscience according to the general prudence principle in accounting.
According to a survey of Truong et al. (2008), the investment appraisals net present value, internal rate of return, payback period as well as return on investment are the most popular and thus most used among companies worldwide. Hence, the following subchapters introduce and discuss these methods in addition to further approaches completing the most-relevant investment appraisal methods in today’s practice.
