SUMMARY

Marketing Investment Analysis:

The critical success factors for financially evaluating and effectively controlling marketing investment decisions. Most large and very many smaller companies are now very sophisticated in how they financially evaluate major investment decisions involving tangible fixed assets. So far the evidence overwhelmingly indicates that companies are far less rigorous in their financial evaluations of long term marketing investment than they are for similar levels of expenditure involving other projects.

Indeed in many companies there is no attempt to distinguish between short term and long term marketing expenditure in terms of the financial evaluation techniques employed, with all marketing activities being regarded as short term, i.e. current period, expenses in line with ‘prudent’ financial accounting conventions.

This is particularly true in the critically important area of justifying the development and launch of new products. The initial phases (e.g. product research and development, market research, test marketing and even pre-launch marketing) are often allocated from a revenue budget and consequently may be controlled in the same way as normal, regular ongoing expenditure items. In such companies, a ‘capital’ investment project would only be raised when the decision to invest in ‘real’ fixed assets, such as a full-scale manufacturing facility, was reached. . +, -. _,I. ._, _..‘I.,. \.) ;.

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1. THE THEORY OF INVESTMENT ANALYSIS

By investment we mean here any outlay on any extraordinary project or effort quite distinct from the normal expenditures connected with ordinary business operations. There are broadly three investment areas in a business from this stand-point. These are la) capital expenditure, (b) new business venture, and (c) new marketing effort.

There may be various types of business needs giving rise to an investment proposal. To define an independent project and to recognise all feasible alternatives to it, identification of the specific need is important. Accordingly, need may be classified as follows:

1) Expansion2) Cost reduction3) Loss/cost avoidance4) Replacement5) Employee welfare6) Improved manufacturing methods7) Quality assurance and good manufacturing practice8) Pollution control

Others (for example, penetration into new markets, improving the market share, etc.)

More often than not, a project would fulfill more than one of sod needs.

After an investment proposal is made, it has to be thorough!) I evaluated. Such evaluation requires collection, integration quantification and analysis of all feasible alternative projects relates to the particular course of action.

It is not difficult to envisage two important components of a project the hardware and the software. In an area development project till I software or the service aspects are more important. In the setting up of a factory, on the other hand, the hardware elements named providing physical assets, are more important, though there would be some software elements also in the form of providing services and utilities.

Any project would require initially the deployment of some physical and financial resources which would provide the basis of the stream of costs. At a later stage will accrue a stream of benefits. Therein distinct time-lag between the stream of costs or investments and the stream of benefits or returns. Both these streams have to be identified in the form of cash flows - both outflows and inflows.

There are five general steps in the approach to most project analyses. These are:

1] problem/project definition;2] recognition of all alternatives;3] collection of all relevant data;

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4] qualitative and quantitative analysis;5] presentation of results to decision - makers.

To handle the above five steps, there are broadly three areas of responsibilities,

1] Those closest to project - for collection of primary data initially and implementation of decision finally;

2] Those responsible for data analysis and assembly of proposals;

3] Those charged with approval/disapproval of the proposal

The management accountant or project analyst is in the second area of responsibility mentioned above.

There are various types of feasibility studies undertaken during aProject analysis. These are:

I] technical feasibility or appraisal;2) organisational set-up;31 managerial competence;4] economic analysis;5| commercial aspects; and6| financial feasibility.

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2. EVALUATION OF FINANCIAL ATTRACTIVENESS OF PROJECTS

As in the case of an individual, in the case of a business also Hit means of finance are limited but the demands for invesimei prospects are numerous. Thus a situation may arise when a Compaq has to choose one among a number of alternative projects Profitability is generally the main criterion in such selection, B« there may be other criteria as well; for example, need for getlin| back the money at the earliest possible time, creation ofemploymen opportunities with emphasis more on the discharge ol responsibilities than on profits, building up a good image of UK enterprise (which might in turn pay back in various ways in to future), and so on.

The tools and techniques used for financial evaluation of projffl I attractiveness are somewhat different at micro level from thoseusedH at the macro level. For example, benefit cost ratio is the mostl common technique applied in the case of projects at the raaoj I level. Under this technique all benefits and costs are amortise) I into annual benefits and costs, respectively, before the benefit cost I ratio is computed. The higher the ratio, the greater will be the IJ financial justification for the project.

There are various methods and techniques of assessing the financial I justifiability of a project. These techniques can be broadly grouped I under two sets, (a) undiscounted methods and (b) discounted I methods.

Undiscounted methods include pay-back period calculation, benefit I cost ratio approach, working out various return on investment (ROI) I percentages, etc. The dominant feature of all these methods is Dial time value concept of money, on the interest element, is not considered at all under these methods.

Interest element or time value concept of money is taken into consideration in the discounted methods. The basic principle adopted here is the farther we move from the present, the lower I be the value at present.

There is thus the need for adjusting both investments and returns in respect of time. Discounted methods also ha' e various approaches, discounted pay-back period, discounted benefit-cost approach, net present value (NPV) approach, DCF rate of TI or internal rate of return (IRR) approach, etc. The results I at under the discounted cash flow techniques can be further refined by adopting more sophisticated techniques like risk analysis I sensitivity studies. We shall now discuss and illustrate these and techniques.

CASH OUTLAY (INVESTMENT

4

Average Income

3. PAY-BACK PERIOD

The pay-back period is defined as the period (number of years and months) at the end of which the net cash flow of a project is zero 0). In other words it is the period during which the original investment (cash outflow) is fully paid back by the returns (cashinflows). An example:

Year Cash Flow Rs. Lakhs

Project A Project B

0 (50) (Investment)

(60)

1 5 202 10 203 15 20 ®04 20 ®0 205 25 206 30 20

The pay-back period is four years in case of Project A and three in case of Project B. Judged by this criterion, Project B is r than Project A. This is how the relative attractiveness of a of competing projects is to be judged under the pay-back Period approach.

The pay pack period is followed by those enterprises which are primarily interested in an early return of the original investment ii> reduce the risk factor or to put the same money to a better alternative use after a period of time which coincides with the pay-back period

Besides this, the pay-back method has some distinct advantages:

1 ] It is simple to understand and easy to calculate

2] It indicates at once an investment which is outright unacceptable (if the total investment is not paid back during the lifetime of the project).

3] In an industry which is experiencing rapid technological changes, The pay-back method ensures some protection against the danger ol obsolescence (since investment decisions are based upon the lowest pay back period approach).

But the pay-back period approach suffers from some seriously limitations:

1 ] It does not consider the interest factor or the time

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value concept of money.

2] It does not consider the staggering of the return Iduring the pay back period. (Two projects mi) I have the same pay back period, but the pattern of I cash flow may be say 15+7+3 in one case audit 5+7+13 in the other).

3] It does not take into account the post pay-badl .period returns which could be significant in soil cases.

In sum, the pay-back period method happens to be the most popular method of project appraisal as revealed in some surveys recently conducted in the western countries. Unfortunately, for some of unknown reasons, this method is yet to gain popularity in the Indian trial enterprises, barring only a few houses.

4. sRETURN ON INVESTMENT (ROI)

The return on investment method is a popular method of judging acceptability of a project. To calculate the ROI both the statement and the returns are to be worked out with proper perspective.

Total investment usually means the net fixed assets (gross fixed is less depreciation) plus net working capital (current assets current liabilities) relatable to a particular project or an alternative. Returns may be either pre-tax or after-tax profit. Sometimes after-tax cash flows are taken to be the returns. This is of course not a healthy practice - ROI being basically an accounting concept, profit should be taken as the numerator, whatever be the profit is defined. For example besides PBT or PAT, sometimes it' (Earnings before interest and tax) is taken to be the returns [he purpose of ROI calculations.

An enterprise should have some minimum expectation in the form ROI percentage. This minimum expectation is called the cut-off of investment. The projects showing ROI below the cut-off rate automatically be excluded from consideration. And obviously, ; one with the highest ROI rate, will be accepted when there are a number of projects competing for a limited or scarce investible fund.

There are various approaches towards working out the ROI even the same project and, therefore, with the same set of data.

ILLUSTRATIONA project costs Rs 50,000 & has a scrap value of RS 10,000. Its stream of income before depreciation & taxes during first year through five year is RS 10,000 RS 12,000 RS 14,000 RS 16,000 & RS 20,000. Assume a 50% tax rate & depreciation on straight line basis. Calculate the accounting rate for the project.

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Calculation of ROI

PERIOD 1 2 3 4 5 AVERAGE

Earnings before dep- & taxes

10,000 12,000 14,000 16,000 20,000 14,000

(-)dep 8,000 8,000 8,000 8,000 8,000 8,000

Net Earnings before taxes

2,000 4,000 6,000 8,000 12,000 6,400

(-)Taxes at 50%

1000 2000 3000 4000 6000 3200

Net Earnings after taxes

1000 2000 3000 4000 6000 3200

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Book value of investment:

Beginning 50,000 42,000 34,000 26,000 18,000

Ending 42,000 34,000 26,000 18,000 10,000

Average 46,000 38,000 30,000 22,000 14,000 30,000

ROI= (3200/30,000)X100=10.67%

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5. THE DISCOUNTED CASH FLOW (DCF) TECHNIQUE IN GENERAL

Discounted Cash Flow or time adjusted return is nothing but present value of different cash flows or returns in different future that is the future returns brought down to the equivalent pr value level by applying suitable discount (or interest) rate Discounting is nothing but the reverse of compounding.

Discounted cash flow technique is breakthrough in the area of project evaluation since, unlike all other conventional methods, this technique for the first time sought to recognise and introduce the! value concept of money or the interest factor. From the core point of view, Rs. 100 payable today is of greater value than Rs.100 payable say, after one year, because of the interest factor involve Assuming a 10 per cent interest rate Rs. 100 today is equivalently| Rs. 110 after one year. Alternatively, Rs. 100 after one year may be discounted to about Rs.90 (at 10 per cent rate), which is really the present value

If we ignore the interest factor and add up all future cash flow absolute monetary terms, it would be fallacy of aggregation sir the addition of amounts would be from different frames of reference. Further, on the basis of this so-called total cash flows if compare the profitability of different projects, that comparison will not be on an apples to apples basis, but between dissimilar Discounted cash flow techniques solves these problems

aggregation and comparison. Therefore, the relative profitability of different projects assessed after the application of DCF technique is both correct and realistic.

As already indicated, there are various approaches in the application of the DCF technique. We will now illustrate these.

DISCOUNTED PAY-BACK PERIOD APPROACH

If we assume a discounting rate of interest rate of 10 per cent and rework the pay back period on the basis of the same set of data given earlier under Projects A and B, the position will be as follows

CASH FLOW(Rs. lakhs)

Project A Project BYear Discounting-------------------------------------------------

factor absolute present absolute presentamount value amount value

1 (50) (50) (60) (60)

.91 5 4.55 20 18.20

.82 10 8.20 20 16.40

.75 15 11.25 20 15.00-0

13.60-0

12.40

.68 20 13.60 20

.62 25 15.50 20

.56 30 16.80 20 11.20

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Notes on Working:

(i) Discounting factors available from discounting tables (orpresent value tables).

(ii) P V in each case = amount of cash flow x the discountingfactor

(iii) Cash flows assumed to accrue at the end of each year.

The pay-back period of the two projects as shown above are<■ years for A and 3.75 years for B. B is therefore better thanA.1 may be noted here that under the undiscounted pay back method also B is considered to be better than A. But on this basis the J back is four year for A and three years for B.

DISCOUNTED BENEFIT-COST RATIO APPROACH

Following the same set of data as above, the Benefit Cost Ratio an undiscounted basis would bee 105/50 = 2.1 for Project A and in case of Project B, 120/60 = 2. On this basis, therefore, Project \ considered to be better than Project B. But if we take the w counted benefit-cost ratio approach, the position is as follows I

Total present value of returnsDiscounted benefit-cost ratio =-------------------------------1

Total investment at present value!69.9

Project A =----= 1.39850

86.8Project B =----= 1.447

60

On the basis, Project B is better than Project A. The results arrived B at (1 398 and 1.447) are also called profitability indices or profit ability factors of the respective projects.

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The net present value (NPV) method is the classic economic method of evaluation the investment proposals. It is one of the discounted cash flow (DCF) techniques explicitly recognized the time value of money. It correctly postulates that cash flows arising at different time periods differ in value and are comparable only when their equivalent –present values-are found out. The steps involved in the NPV method are: First, an appropriate rate of interest should be selected to discount forecasted cash flows. Generally, the appropriate rate of interest is the firm’s opportunity cost of capital which is equal to the minimum rate of return expected by the investors to be earned by the firm on its investment project. Second, the present value of investment proceeds (i.e., cash inflows) and the present value of investment outlay (i.e., cash outflows) should be computed using opportunity cost of capital as the discounting rate. If all cash outflows are made in the initial year, then their present value will be equal to the amount of cash actually spent. Third, the net present value (NPV) should be found out by subtracting the present value of cash inflows. Accept the project if NPV is positive (NPV >0). Thus, the NPV method is a process of calculating the present value of cash flows (inflows and outflows) of an investment proposal, using the opportunity cost of capital as the appropriate discounting rate, and finding out the net present value by subtracting the present value of cash outflows from the present value of cash inflows.

ILLUSTRATION

For Project X which initially costs Rs 2,500 and generates year-end cash inflows of Rs 900, Rs 800, Rs700, Rs 600, Rs 500 in one through five years. The opportunity cost of capital is assumed to be 10 %

Year Cash inflowsin Rs

Discounting Factor At 10%

PV of cashInflows in Rs

1 900 0.9091 8182 800 0.826 6613 700 0.751 5264 600 0.683 4105 500 0.620 310

2725 Less Investment Outlay -2500 Net Present Value +225

The Net Present value for Project X can be calculated by referring to present value table, where we find appropriate discount factors. Multiplying the discount factors and cash inflows, we shall obtain the

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present value of cash inflows. The difference between the present value of cash inflows and the initial cash outlay will represent the net present value.

Formula to find NPV:

NPV=

Internal Rate Of Return Method (IRR)

Rate of return can be defined as one which equates investment outlay with the present value of inflow received after one period .This also implies that the rate of return is the discount rate which makes NPV=0 .There is no satisfactory way of defining true rate of return of a long-term asset. The internal rate of return (IRR) is the best available concept. We shall see that although it is a very frequently used concept in finance, yet at time it can be a misleading measure of investment worth.

Definition for IRR It can be defined as that rate which equates the present value of cash inflows with the present value of cash outflows of an investment. In other word, it is the rate at which the net present value of the investment is zero. It is called internal rate because it depends solely on the outlay and proceeds associated with the project and not any rate determined outside the investment. It can be determined by solving the following equation for r:

ILLUSTRATION

A project costs Rs 16000 and is expected to generate cash inflows of Rs8000, Rs7000 and Rs6000 over its life of three years. You are required to calculate the internal rate of return of the project.

To start with, we select (arbitrarily) a rate of 20% and calculate the present value of cash inflows:

Year Cash inflowin Rs

Discount factorAt 20%

Present valuein Rs

1 8000 0.899 66642 7000 0.694 48583 6000 0.579 3474 Less Cash outlay 14996

16000 NVP -1004

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The Net present value indicates that this is a higher rate. Therefore, lower rates should be tried. We try 18%, 16%, 14%, obtain the following results:

Year Cash inflow

Discount factorDF 18%

PV DF 16%

PV DF 14%

PV

1 8000 0.847 6776 0.62 6896 0.877 70162 7000 0.718 5026 0.743 5201 0.769 53833 6000 0.609 3664 0.641 3846 0.675 4050

15456 15943 16449 Less Cash outlay 16000 16000 16000 NVP -544 -57 +449

When we select 15% as the trial rate we find that the net present value is + Rs 200

Year Cash inflow DiscountFactor at15%

Presentvalue

1 8000 0.870 69602 7000 0.756 52953 6000 0.658 3948

16200 Less Cash Outlay 16200 NPV +200

The true rate of return, thus , should lie between 15-16 %.

6. NET PRESENT VALUE (NPV)

Under this approach, a suitable discounting rate is first decided upon. Usually, this rate is equal to more than the cost of borrowing or cost of capital for investment. Thereafter all the cash flows - both out (investment) and in (returns) - are converted into their respective present values applying the discounting rate. To facilitate the work discounting tables are used (which show PV of Re 1 at different | periods and under different discounting rates). The net total present value of all projects is then computed.

An illustration

Continuing the same example in respect of Projects A and B we may work out the NPV (assuming as before, a discounting rate of 10 per cent and cash flows accruing only towards the end of the respective years.)

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CASH FLOWS (in Rs. lakhs)PROJECT A

PROJECT B

(i)PV of (investment) (50) (60) (ii)PV of returns (total of

all future returns, as calculated earlier)

(iii) Net present value (NPV)

Ratio of NPV to PV of

investment NPV as percentage

of PV of investment

Let us now indicate the decision rules under NPV approach :

(i) A project showing negative NPV is to be summarily rejected (since it does not recover the original investment).

(ii) Criterion of project selection is the absolute NPV amount if the PV of investments of the competing projects are around the same.

(iii) Criterion of project selection is the ratio (or percentage) of NPV to the PV of investments for the respective projects in a situation where the PV of investments of the competing projects are significantly different. .

Following the decision rule (iii) above, Project B is considered to better than Project A.

7. INTERNAL RATE OF RETURN (IRR) APPROACH

One of the major problems of the NPV approach is that of deciding A upon the correct discounting rate. Needless to say. any improper decision in this respect may vitiate the project profitability analysis, particularly in cases where different projects show \\M different patterns of cash flows in different time periods.

69.9

0

19.0

0

0.39

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This problem is obviated by a slightly more refined approach or. DCF technique. This is the DCF rate of return (also called ■ adjusted rate of return) approach or the IRR calculation Under this approach, the NPV of each competing project is assumed to'be ZERO and that unique discounting rate which would make NPV = O is to be arrived at separately for each project. The project showing § highest discounting or DCF rate or IRR is considered to be the best.

The methodology of arriving at the DCF rate is initially trial m error and then use of interpolation techniques, once the area of rate is located after two or three trials.

An Illustration

Let us continue with the same set of data for clearer understands Assume the discounting rate of 10 per cent is not given We have find the unique discounting rate in respect of each of the projects, A and B, which would result in a zero NPV in either case.

It would be clear from the earlier workings that the DCF rate wt be higher than 10 per cent in either case (since at 10 per cent is then are positive NPV's). Let us start with a higher rate in the first trial for each of the two projects and come down, if necessary, in subsequent trials Incidentally, it may be noted that higher the ratio discount we choose ,the lower will be the present value of returns Our objective is to make it zero.

PROJECT A

Trial No 1 Trial No 2

Year Cash Discount Rate 20% Discount Rate 18%

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Flow factor P.Y factor PV.(Rs. lakhs) (Rs. lakhs) (Rs. lakhs)

16

(50) 1.00 (50.00) 1.00(50.00)

51015202530

1.00 (50.00)0.83 4.150.69 6.900.58 8.700.48 9.600.40 10.000.35 10.50

0.85 4.250.72 7.200.61 9.150.52 10.400.44 11.000.37 11.10

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PV (0.15) 3.10

From the two trials, it is apparent that the DCF rate must lie somewhere between 18 per cent and 20 per cent. The rate may be arrived K interpolation as follows :

NVP of low trialDCF rate = Rate of low trial +-------------------X DiflF. in rate

NP V of low trial + deficit betweenin NPV of high trials two trials

3.10= 18% +--------------X 2%

3.10 + 0.15 = 18%+1.9% = 19.9% (or approximately, 20%)

PROJECT B

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Trial No. 1

Trial No.2

19

Year

0 1 2 3 4 5 6

N.P.V

Cash Flow (Rs. lakhs)

(60) 20 20 20 20 20 20

Discount Rate 25%factor PV.

(Rs.Iakhs)

(60.00) 16.00 12.80 10.20 8.20 6.60 5.20

(1.00)

Discount Rate23̂ factor PV (Rs.Iakhs)

1 00 (60.81 160.66 130.54 100.44 8.0.36 7.0.29 5.

1.00 0.80 0.64 0.51 0.41 0 33 0.26

20

2.00DCF Rate = 23% +

2.00+ 1.00 = 24.33% (or approximately, 24%)

DCF rate or IRR being higher in case of Project B. this would I better than Project A. The fact that both unider undiscountcd | back method and under DCF rate, Project B in the example is i attractive, is more a coincidence than due to an\ specific re Take the following case, for example :

X2%

Year end... 1 2 3 4 5 6Cash Flow:

Project X (40) 10 10 10 !0 10Project Y (40) 4 8 12 16 2

7.. 11

PAY-BACK PERIOD DCF RATE OF RE1

Project X : Project Y

4 years 4 years

19% 25%

In spite of the same pay-back period, DCF rate differs significantly.

It would be to our advantage to tabulate and study all the results. obtained under various methods, in respect of Projects A and B.

Methods Project A

Project B Relative

attractiveness

UNDISCOUNTED : I Pay-back period 2.R01

3Benefit cost ratio DISCOUNTED :4 Benefit cost ratio (profitability factor)5 Pay back period6Net present value(percentage oninvestment)

7DCF rate (or IRR)

4 vears 3 years B70%, 35 67%, 57%, 33% A

& 40% & 33%2.1 2 A

1.398 1.447 B

4.8 years 3.75 years B

39.8% 44.7% B

20% 24%

8. NPV VERSUS IRR

VPV indicates the excess of the total present value of future returns over the present value of investments IRR (or DCF rate) indicates, on the other hand, the rate at which the cash flows (at present values), are generated in the business by a particularproject.

Both NPV and IRR iron out the differences due to interest factor or. say, higher returns in earlier years vis-a-vis higher returns in later years (through the total returns in absolute terms may be around the same for several projects).

Between the two, IRR or DCF rate is the more sophisticated method • a popular method as well, since :(a) IRR method obviates the mostly subjective decision regarding discounting rate.

(b) Whilst under NPV the main basis of companion [ is between different NPV's of different projects under IRR or DCF rate approach a number of bases I is available, for example :

DCF rates vs current rate of return (on normal operations)!DCF rates vs cut-off rate of the companyDCF rates Vs borrowing rate (or cost of capital)DCF rates between different projects.DCF rates of different projects vs. those of similar projectsof other companies.DCF rates of different projects vs DCF rates of similarprojects undertaken in the past, (c) The results under DCF rate approach are simpler for

the man agreement to understand and appreciate.

We should, however, be very careful in applying the decision rules properly when NPV and IRR calculations show divergent resultsThe rules are(a) NPV should be the basis of decision when

(i) the projects are mutually exclusive in character, and (ii) there is a capital rationing situation.

Illustration On (ii) Above

Assume there is a capital constraint of Rs.300 and there are: projects the figures being as follows :

Projectt

Investment First year and

NPV IRR

Cash FlowRs. Rs at 10% Rs %

F 100 120 9.08 20%G 100 119 8.17 19%H 100 112 1.81 12%I 200 232 10.89 10%

J 300 354 21.79 18%

Under IRR approach, F, G and H will be selected (total investment required is Rs.300). But this would not be obviously correct. Project J should be the right selection in the case, based on NPV results The criterion we are adopting here is maximising the total returns

(b) IRR should be a better guide when there are plenty of project situations (as it is there in a big enterpnee) and no major capital constraints (for example, in respect of macro-projects).

9. THE DCF TECHNIQUES - CONCLUDING OBSERVATIONS

Cash flows have to be calculated in accordance with the method explained earlier. To recapitulate, the simple formula to be followed is estimated profit - tax + interest + book depreciation (the depreciation debited to P/L a/c whether it be the same as or different from the tax depreciation.

The discounting factors should be taken up to four or five places of decimals from the table (not two places as we have taken forconvenience).

Timing of cash flow is important in any DCF calculation Sometimes, investments may be staggered over a period that may have started in the past. In such cases, all past cash flows should be discounted forward by applying suitable discount factors to elevate them to the present value platform.

In all our illustrations worked out earlier, we have made a simplistic assumption that all cash flows arise only towards the end of the year In reality, however, cash flows generate in most cases evenly during a year Discounting tables are available for such even cash flows also. For example, 0.91 may be the discount factor at 10 per cent for Re. 1 to be generated at the end of one year from now If it is generated evenly throughout the year, the discounting factor at the same 10 per cent rate would be say, 0.955.

For DCF calculation, a project may be cut off after, say, five, eight I or eight I. If this is done for all the competing projects, the DCF I rates will not be significantly affected, though they may have I different life spans and widely different patterns of return after tbat I 10-year period.

Lastly we may indicate here a few limitations of the DFC technique, to be borne in mind always in its application:

(i) DCF takes care of the time value concept of Imoney, but not the value of money as based on I purchasing power. Inflation element is, therefore, I to be considered separately (say, while estimating I costs, revenues and cash flow).

(ii) IRR results would be valid provided there is scope for reinvestment of cash flow of returns all the time. The condition may not exist always.

(iii) Monitoring of actual cash flow on DCF basis (to ensure that actuals conform to earlier estimates) is almost impossible in real life business situations.

10. RISK ANALYSIS

Risk analysis is an attempt to reduce (if not eliminate) the element of risk involved in any investment decision, which is basically, and essentially a leap into the future.

The basic data of most of the investment analyses are the sales forecasts. The actual result may be widely different from the one anticipated if there is any error in sales forecasting and/or if reality does not conform to the situation envisaged. If instead of a deterministic forecast, we go by a probabilistic sales forecast, the risk element may be reduced to some extent. Needless to say, the probabilities would only be subjective probabilities given by responsible people closest to the proposed project. Let us consider the following situation:

PROJECT "P"

Probability of DCF ratesuccess

0.05 30%0.65 18%0.30 9%

1.00

The weighted average DCF rate is 16 per cent (profitabilities being taken as the weight). This gives a better and more reliable rate than any one of the three given above.

Of course, it may be argued that if the worst comes to the worst, forecast 'C may come true and we may net a meagre 9 per cent return. But some amount of calculated business risk must always be there, and more so in all investment decisions.

In risk analysis, the Bayesian decision model can also be used. This approach allows a flexible detailed model to be built for a specific decision problem and uses explicit probabilities to reflect uncertainty. Furthermore, it provides an estimate of the value of additional information in reducing the uncertainty.

Sales forecast

alternativesABC

11. SENSITIVITY ANALYSIS

Sensitivity analysis is a further refinement in project profitability appraisal. The purpose is to show:

(i) The profitability of alternative sets of estimatesFor a project; and (ii) The effect on profitability of variations in the factors involved.

Let us assume that against the estimates of three major factors of a project, variable cost may go up or down by 10 per cent; sales forecast may differ by 20 percent and fixed cost may be up or down by 5 per cent. Considering all such probable changes, a 'pay-off matrix' may be formed and the degree of sensitivity worked out.

Sensitivity analysis, in essence, seeks to highlight the extent to which the original decision will remain unchanged despite some changes in the factors involved. Assume that DCF rate of a project is calculated to be 25 per cent and cut-off rate of the company is 15 per cent There being no other viable alternative, a go-decision is being considered Now, it is also estimated that the sales forecast originally taken may go down by 20 per cent and in that case the DCF rate of return is also calculated to come down to, say. 15 pci cent. The logical conclusion would be that the go-decision is unchanged up to 20 per cent reduction in anticipated sales and that it would probably be a 'no-go7

decision if sales are apprehended to be down by more than 20 per cent over the forecast. Following the same approach, we may considered the effect on the DCF rate of return of increase or decrease in variable cost and also fixed cost These have to be taken into account in sensitivity analysis and results suitably included in the project analysis report for presentation to the decision-makers.

CONCLUSION

The financial justification of marketing investment decisions is an essential requirement for ensuring that these major strategic decisions, when implemented, are effective in achieving the companies pre-set objectives.

This means that there should be a greater separation of financial reporting and management accounting systems so that managers have the information that they need to evaluate their decisions over the long term, and are not in any way constrained by the short term prudent requirements of external financial reporting.