Making the strategic investment decision

Strategic investment decisions convert a direction of travel into a commitment of scarce capital. Whatever valuation method you use, keep three fundamentals in view: compare incremental future cash flows, exclude sunk costs, and recognise that cash received later is worth less than cash available today.

When to use it

Use this approach when you must choose among strategic alternatives with different costs, benefits, timing and risks. Use payback only as a screening method when a full discounted-cash-flow analysis is disproportionate or unavailable.

Origins

Robert Frost’s image of two diverging roads is a useful metaphor for strategic choice, but the financial logic comes from capital budgeting and value-based management. Those disciplines developed methods for comparing an immediate investment with cash and other benefits expected over time. Their central ideas are incremental cash flow, the irrelevance of costs that cannot now be recovered, and the opportunity cost of capital.

What it is

The method compares mutually exclusive strategic alternatives and asks which creates the greatest value at an acceptable level of risk, while still respecting non-financial stakeholder goals.

At one end of the evaluation spectrum are sophisticated methods such as real-option valuation; at the other are shortcuts such as the immediate effect on earnings. Two practical options sit between those extremes: discounted cash flow, or DCF, and payback.

DCF forecasts the incremental free cash flows generated by each alternative and discounts them to Year 0 to calculate net present value, or NPV. Payback estimates how long it takes the resulting cash benefits to recover the original investment. Neither method removes uncertainty. Their purpose is to make assumptions visible, comparable and testable.

Three rules apply throughout. First, include only future cash flows that differ because the alternative is pursued. Second, ignore expenditure already incurred: it is sunk and cannot be changed by the decision. Third, account for timing because capital committed now could otherwise earn a return elsewhere.