Accepting as a basic premise the importance of capital investment decisions for the firm and the significance of risk and uncertainty in forward planning, the research study reviews investment decision theory and examines alternative modifications to this theory to accommodate risk and uncertainty. Recommended modifications to data input, methods of project evaluation, and reporting produce a programme which varies significantly from generally accepted investment theory and practice.
Risk and uncertainty is explicitly recognised through their influence on input variables: investment outlays, lifespans, volume of project outputs, selling prices and variable costs per unit of volume, period fixed costs, reinvestment opportunities and residual benefits. In the programme, a range of values (with subjective probabilities for each value) is determined for each input variable. Uncertainty is converted to a "risk-equivalent" situation.
Input data is analysed initially using a Monte Carlo technique to simulate profitability and each range of data is further reduced to an "expected value" to form the basis for profitability calculations and an evaluation of investment sensitivity to changes in input variables. In both the simulation and sensitivity analyses, four indexes are used to measure investment profitability - internal rate of return, internal rate of return modified to incorporate explicit reinvestment opportunities, accounting rate of return, and the payback calculation. In reporting the results of simulation and sensitivity analyses, extensive use is made of graphs.
After illustrating the programme of analysis with a theoretical investment project, the programme is evaluated on the basis of eight case studies - investment projects currently under consideration by executives of Australian manufacturing companies.
Experience with the case studies leads to the following conclusions:
1) The significance of investment risk and uncertainty is identified for decision-makers if projects are evaluated with a programme incorporating simulation and sensitivity analyses.
2) The investment analysis programme provides valuable information for management not currently available from methods in use by accounting executives of Australian manufacturing companies.
3) Ranges of values for input variables are readily obtainable from accounting, production and sales executives. Little difficulty is found in assigning subjective probabilities to ranges of values.
4) An internal rate of return analysis which explicitly considers reinvestment opportunities, and "rule-of-thumb" methods of analyses have an important role in identifying risk and uncertainty for investment decisions. When the results of analyses are presented as graphs, management interpretation of these analyses is assisted and subsequent decision-making is most effective.
5) Widespread acceptance and implementation of the recommended investment analysis programme by members of the accounting profession must depend on current and future educational policies of professional bodies producing financial executives with a sound knowledge of computer mathematics, statistics and financial analysis.