Management And Accounting Web

Investment Management Summary

Provided by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida

Investment Management Main Page | CAM-I Main Page

Citation: Martin, J. R. Not dated. Investment management. Management And Accounting Web.

This Summary includes notes from 13 summaries related to Investment Management.

1. Martin, J. 1983. Management accounting: A powerful method of influencing behavior. Cost and Management (December): 4-9.

On page 7 of this article I summarized an old, but still unresolved capital budgeting issue as follows:

"Conflict between DCF and AC models. When performance evaluation for capital budgeting projects is based on the accrual accounting (AC) model (i.e., ROI and RI), managers may be reluctant to use the conceptually correct discounted cash flow (DCF) models (i.e., net present value (NPV) and internal rate of return (IRR)) for choosing projects. The first year’s ROI based on accrual accounting or tax depreciation methods (i.e., straight line, sum-of-the-year’s digits, declining balance, or the accelerated cost recovery system) will normally be well below the internal rate of return (IRR) expected, even when actual cash flows match predictions.

The remedy is to use net book value based on compound interest depreciation as the denominator in the ROI calculation. Then the ROI used to evaluate actual performance will agree with the IRR expected, as long as actual cash flows match predictions. This approach provides the correct behavioral signals to management by eliminating the inconsistency between the DCF decision model and the AC performance evaluation model. An alternative approach involves restating DCF predicted results in an accrual accounting format so that subsequent performance can be evaluated with the AC model." (End of article note.)

An example illustrates the idea.

This method is also referred to as the annuity method of depreciation.

Depreciation for year i = Cash flow for year i - (IRR)(book value at the start of year i).

Where i ranges from 1 to the number of years in the life of the investment.

Cost of Project $7,132 Two year life, Annual net cash inflow $4,000.

IRR = 8% (See table below).

Present Value Analysis
Year Cash Flow Discount Factor
(8% Cost of Capital)
Discounted Cash Flow
0 $(7,132) 1.000 $(7,132.00)
1 4,000 .9259 3,703.60
2 4,000 .8573 3,429.20
NVP $0

Interest Return Year 1 = ($7,132)(.08) = $571.00

Depreciation Year 1 = $4,000 - 571 = $3,429.00

Interest Return Year 2 = ($7,132 - 3,429)(.08) = $296.24

Depreciation Year 2 = $4,000 - 296.24 = $3,703.76

Comparison of Compound Interest depreciation with Straight line and Sum-of-the-years-digits. Assume actual cash flows are equal to expected cash flows.

Compound Interest Straight Line Sum-of-years-digits
Year 1 2 1 2 1 2
Actual net cash inflow $4,000 $4,000 $4,000 $4,000 $4,000 $4,000
Depreciation 3,429 3,704 3,566 3,566 4,755 2,377
Net income $571 $296 $434 $434 $(755) $1,623
ROI* 8% 8% 6% 12% -11% 68%
* Net Income ÷
Net Book value:
571/7132 296/3704 434/7132 434/3566 (755)/7132


Now assume actual cash flows are not equal to expected cash flows. Under the compound interest method, a net cash inflow in a given year that is different from the expected amount will cause the ROI to be different from the estimated IRR. For example, suppose the net cash inflow for year 2 above is $3,900. The ROI drops to 5.3% as illustrated below.

Compound Interest Method
Year 1 2
Actual net cash inflow $4,000 $3,900
Depreciation 3,429 3,704
Net income $571 $196
ROI* 8% 5.3%
* Net Income ÷ Net Book value 571/7132 196/370

Why the Compound Interest Method is not used.

1. Hard to understand and not consistent with external reporting.

2. The depreciation charge increases over the life of the asset. This seems to violate the
matching concept.

3. There is a possibility of negative depreciation in some years.

2. Howell, R. A. and S. R. Soucy. 1987. Capital investment in the new manufacturing environment. Management Accounting (November). (Summary).

When investing in automation, managers need to understand and perhaps redesign and simplify the manufacturing process before new investments are considered.

What’s new in terms of the investment environment?
According to Howell & Soucy, new investments in automation

1. Are more risky, i.e., involve more uncertainty.
2. Require large cash outlays.
3. Require longer periods to implement.
4. Require larger engineering and software costs.
5. Involve more complexity.
6. Cash returns are received over a longer time period including longer
periods of negative cash flows.
7. Involve benefits that are more indirect and intangible, e.g., come in the form of
improved quality, delivery, throughput, flexibility, customer satisfaction as well
as cost reductions.

They argue that the discounted cash flow model is still appropriate, but the inputs used in the analysis need to be reconsidered. They also discuss different levels of investments from robots to flexible manufacturing systems to Greenfield factories and suggest that the criteria needed to justify investments at each level is different.

Some recommendations for investment analyst:

1. Should not exclude or excessively discount the terminal value of an investment.
2. Should not use incorrect or artificially high discount rates.
3. Should use the moving baseline concept.
4. Conduct post investment audits. Audit the cash flows and other benefits
and explain reasons for differences in expected and actual results.
5. Management accountants should not rely exclusively on existing cost
systems to justify investments. Must consider other benefits beyond the
financial information.

The moving baseline concept : Don’t evaluate the investment against the status quo. Instead, analyze the investment against what is likely to happen to the company’s competitive position and cash flows if the investment is not made. They illustrate this with Figures 3 and 4 in the paper.

3. Sinason, D.H. 1991. A dynamic model for present value capital expenditure analysis. Journal of Cost Management 5 (Spring): 40-45. (Summary).

Sinason argues that the old capital budgeting model is static and that a new dynamic moving baseline model is needed that incorporates the non-investment forecast. The analysis includes estimating the effects of such things as: 1) how the competition might react and potential decreases in market share, 2) increased maintenance costs for the existing investment, 3) increased inventory costs, e.g., resulting from existing longer cycle time for the old equipment or process, 4) losses resulting from not improving quality, e.g., scrap, spoilage, rework and customer dissatisfaction that could be avoided if the new investments were implemented. He provides two examples to illustrate the moving baseline approach that are similar to the example provided by Howell and Soucy.

(Sinason's Moving Baseline examples).

4. From Engwall, R. L. 1989. CIM/JIT investment justification. Journal of Cost Management, 3 (Fall): 35-39.

Engwall includes a discussion of many of the points mentioned in the Howell/Soucy paper above, but adds a discussion of how benefits, risks and effects change for different levels of investment. I summarized these ideas in the exhibit below and filled in the two middle rows based on the implications of his discussion.

Investment Level





Impact on organization

Time perspective

1. Stand alone -






Short term

2. Cells - FMC







3. Linked islands
- FMS*







4. Full integration
- CIM*



Very large

System wide

Very Extensive

Long term

* FMS refers to flexible manufacturing systems. CIM refers to computer integrated manufacturing.

Note: The MADM is also mentioned in this paper. See the discussion from the CAM-I conceptual design below.

5. Shields M. O. and S. M. Young. 1991. Managing product life cycle costs: An organizational model. Journal of Cost Management (Fall): 39-51. (Summary).

Strategies for implementing Cost Management Systems (CMS)

1. Revolutionary - All parts of the company are changed simultaneously.

2. Evolutionary - One part of the company is changed at a time.

3. Green Field - A pilot company is started based on the new model.

6. McNair, C. J., W. Mosconi and T. Norris. 1988. Meeting the Technology Challenge: Cost Accounting In A JIT Environment. (Chapter 10) Montvale. NJ: National Association of Accountants.

In a section of this chapter labeled "Capital Assets and Project Justification" they begin with the following quote from a 1986 paper by Dilts and Russell. "A lot of management uses a capital budgeting model like a drunk uses a lamppost - for support, rather than illumination."

They discuss several problems with traditional capital budgeting models:

1. The qualitative long-term benefits of many advanced manufacturing
techniques, such as quality and responsiveness are not included in the model.

2. Management intuition is not included in the model in a formal manner.

3. The model focuses only on the quantifiable benefits of a project.

4. Opportunity costs are excluded from the model.

5. The discounted cash flow (DCF) model is typically used to rationalize
investment decisions that have already been made.

6. Investments in JIT, FMS and CIM represent investments that impact the
company’s strategy and culture and cannot be rationalized by DCF techniques.

7. Analytic techniques can be used to reduce uncertainty but in the end
management intuition makes or breaks an organization.

7. Berliner, C., and J. A. Brimson, eds. 1988. Cost Management for Today's Advanced Manufacturing: The CAM-I Conceptual Design. (Chapter 7) Boston: Harvard Business School Press.

Chapter 7 provides a discussion of three competitive investment strategies outlined in the exhibit below. Technological risk is high for the proactive technological leaders while market share risk is low. Market share risk is high for reactive firms that wait until the technology shows clear profit potential before entering the market. However, technological risk is low for the reactive firm. Responsive firms have a more balanced set of risks.

Three Competitive Investment Strategies

Three Competitive Investment Strategies
Strategy How to Implement Type of Risk
Proactive To become a technological leader a company needs to develop and use the leading edge technology. Technological risk is high. The company may invest in technology that fails to provide the expected advantage. However, the potential profitability is high.
Responsive Invest after the technology has been proven but not widely used. Technological risk is lower, but still present. Market share risk, i.e., risk of losing market share to the technological leader is also present and varies with the response time. Potential profitability is lower than for the technological leader.
Reactive Wait and buy the technology when it is available "off the shelf". Market share risk is high, but technological risk is very low. Potential profitability is lower than for proactive and responsive firms.

The Multiple Attribute Decision Model

Chapter 7 also includes a method of analyzing investments referred to as the Multiple Attribute Decision Model (MADM). The approach is outlined below. See the Engwall 1988 summary for more on the MADM approach to investment analysis.

1. Define the critical factors:
Financial quantitative - e.g., NPV, ROI, operating margin, level of investment,
level of savings.
Non-financial quantitative - e.g., throughput time, process yield, schedule
attainment, lead time.Qualitative - e.g., the process, basic R&D, technological and product obsolescence.

2. Weight the critical factors. Must sum to 100%.

3. Assign a value to prioritize the critical factors from most important to least important.

4. Assign a risk level.

5. Calculate a value = (Weight)(Value)(Risk).
The highest value is the best project.

For a somewhat similar approach to investment analysis see the Lyons, Gumbus & Bellhouse summary.

8. and 9. Hayes & Wheelwright 1979 HBR articles:

Hayes, R. H. and S. C. Wheelwright. 1979. Link manufacturing process and product life cycles. Harvard Business Review (January-February): 133-140. (Summary).

Hayes, R. H. and S. C. Wheelwright. 1979. The dynamics of process-product life cycles. Harvard Business Review (March-April): 127-136. (Summary).

Hayes and Wheelwright provide a broader discussion of competitive strategy using what they refer to as a product-process matrix. The following illustration provides a graphic view of investment alternatives.

Product-Process Matrix

In the second article, Hayes and Wheelwright build on the product-process matrix and provide a discussion of strategy choices that are similar to the discussion in Chapter 7 of the CAM-I conceptual design. Firms in cell A (See below) fit into the CAM-I proactive technological leader category, but leave the market early to pursue more innovations. Firms in the B cell are also technological leaders, but stay in the market throughout the product's life cycle. Firms in cell C are either responsive or reactive depending on how long they wait to enter the market. Firms in cell A would have high technological risk, but low market share risk. Firms in the B cell would have less technological risk, but perhaps higher market share risk if they don't continue to be innovative. Firms in cell C have lower technological risk, but higher market share risk.

Combinations of Entrance & Exit Strategies

10. Engwall, R. L. 1989. Need for change. Journal of Cost Management 3 (Summer): 51-54.

Engwall argues that making the right investment decisions requires:

1. A change in the corporate culture.
2. A change in the organizational structure.
3. A change in human resource management.
4. An integrated approach to investment analysis including people, technology and product
and process quality issues.
5. Elimination of the short-term investment mentality.

People at all levels need to be involved in the decision making process. Engwall recommends an idea he refers to as "sociointegration" which represents a blending of social and technical systems where the organization becomes horizontal (flat) rather than a hierarchical (vertical top down). The idea includes a consensus-team building, bottom up approach.

11. Hayes, R.H., S.C. Wheelwright and K. B. Clark. 1988. Dynamic Manufacturing. (Chapter 3) New York: The Free Press.

These authors discuss several problems with the capital budgeting model.

Problems of Implementation:

1. Managers assume that the base case is the status quo. This causes a disinvestment spiral (i.e., deferred investments), that causes reduced profitability and reduces the incentive to invest. This status quo assumption also implies that an investment can be delayed with no penalty other than that contained in the discount rate. (This relates to the moving baseline idea discussed by Howell/Soucy and Sinason.)

2. Managers fail to incorporate non-financial, or non-quantifiable considerations that biases decisions against investments that impact the quality and reliability of the company’s products, delivery speed and the time required to introduce new products.

3. Using hurdle rates (i.e., discount rates) that are too high, i.e., hurdle rates that are well above the company’s long term cost of capital even after adjustments for risks.

Problems of the Underlying Theory:

1. The capital budgeting model is based on a project by project analysis, i.e., it does not recognize and incorporate the interdependencies between investment projects. Taken to its logical extreme, one should combine a new investment with all previous and future investments. There are many interdependencies between investments in JIT, CAD, FMS and CIM. The full advantages of such a series of investments only materialize when all are in place. DCF project by project analyses imply that none of the investments are justifiable. (Evaluating all investment projects as a whole is the portfolio concept.)

2. Projects with different lifetimes are difficult to compare using the DCF model. Decisions should be based on the long term strategic impact on the health and vigor of the firm.

3. The DCF model ignores the differences between pure R&D experimental study type investments and less uncertain equipment replacements. R&D projects may create a high degree of learning in an organization that creates new options for the future. Many such investments resemble the ante in poker. A player does not expect any return from the ante since it only allows one to stay in the game.

Problems Associated with Human Behavior:

1. The assumptions of DCF techniques are not understood by many who should be involved in the decisions. But failure to include lower level people may hide important implementation and coordination issues.

2. The DCF model creates a bias towards large projects. But the secret to building a world class company often lies in making many small investments over a long period of time.


1. Analyze how a capital investment might create a competitive advantage, i.e., how it affects the company’s products and capabilities and how it will affect the company’s commercial and technical capabilities.

2. Compare these expected effects with competitors’ capabilities.

3. Examine how the investment fits with the strategic directions of the company and major functional areas. Investments should be viewed as part of a sequence of investments and opportunities that take the company down a particular strategic path.

12. Martin, J. R. 1994. A controversial issues approach to enhance management accounting education. Journal of Accounting Education. (Winter). (Summary).

Critics argue that the DCF model ignores the synergistic linked benefits of investments that must be considered as a portfolio to achieve an integrated strategy. For example, a company may decide to pursue a proactive strategy in some areas in which the company competes, (i.e., attempt to become a technological leader), a responsive strategy in other areas (i.e., invest after the technology has been proven), and a reactive strategy in the remaining areas (i.e., buy technology off the shelf). By analyzing investments on an individual basis, an integrated strategy cannot be achieved. Another criticism is that the traditional capital budgeting approach is static in the sense that operating and competitive conditions are assumed to remain constant regardless of the investment decision. What is needed is a dynamic moving baseline approach that incorporates the effects of not investing into the analysis. For example, if a company chooses not to invest in a computer integrated manufacturing system, what will be the effect on the company's competitive position in terms of quality, reliability, flexibility, customer responsiveness and market share? Intangible factors are frequently more important than the identifiable cash flows.

Arguments for the defense of traditional capital budgeting are based on the idea that the technique is valid if it is used correctly. The approach is not based on the assumption that intangible, non-quantifiable factors should be ignored in the investment process. The traditional capital budgeting approach includes the recommendation that all important factors should be considered in the investment decision including quantitative financial, quantitative non-financial and also qualitative factors. Companies that only consider quantitative financial data are simply misusing the technique. In addition, advocates of the portfolio idea seem to ignore the fact that investment analysis is not costless. Taken to the extreme, an investment proposal would have to be considered in terms of the interdependencies between all current, all past, and all future investments. There is clearly a practical limit to the number of investment projects that can be evaluated simultaneously. The portfolio approach is perhaps sound in theory, but not feasible in practice.

13. Effect of Front End Investments on the PLC - Adapted from Chapter 7 of the CAM-I Conceptual Design, Figure 7.2

Effect of Front-end Investments on Product Life Cycle Costs


References and related summaries:

Berliner, C., and J. A. Brimson, eds. 1988. Cost Management for Today's Advanced Manufacturing: The CAMI Conceptual Design. Boston: Harvard Business School Press. (Summary).

Engwall, R. L. 1988. Investment evaluation methodologies. Journal of Cost Management (Spring): 40-44. (Summary).

Engwall, R. L. 1988. Cost/benefit analysis. Journal of Cost Management (Fall): 64-70. (Summary).

Engwall, R. L. 1989. Investment justification issues. Journal of Cost Management (Spring): 50-53. (Summary).

Engwall, R. L. 1989. Need for change. Journal of Cost Management (Summer): 51-54.

Hayes, R. H. and S. C. Wheelwright. 1979. Link manufacturing process and product life cycles. Harvard Business Review (January-February): 133-140. (Summary).

Hayes, R. H. and S. C. Wheelwright. 1979. The dynamics of process-product life cycles. Harvard Business Review (March-April): 127-136. (Summary).

Hayes, R. H., S. C. Wheelwright and K. B. Clark. 1988. Dynamic Manufacturing: Creating the Learning Organization. New York: The Free Press.

Howell, R. A. and S. R. Soucy. 1987. Capital investment in the new manufacturing environment. Management Accounting (November): 26-32. (Summary).

Lyons, B., A. Gumbus and D. E. Bellhouse. 2003. Aligning capital investment decisions with the balanced scorecard. Journal of Cost Management (March/April): 34-38. (Summary).

Martin, J. R. Not dated. Moving baseline examples from Sinason. Management And Accounting Web.

Martin, J. R. 1983. Management Accounting: A powerful method of influencing behavior. Cost And Management (November-December): 4-9 and in French 10-15.

Martin, J. R. 1994. A controversial issues approach to enhance management accounting education. Journal of Accounting Education (Winter): 59-75. (Summary).

McNair, C. J., W. Mosconi and T. Norris. 1988. Meeting The Technology Challenge: Cost Accounting In A JIT Environment. Montvale, NJ: National Association of Accountants.

Shields M. D. and S. M. Young. 1991. Managing product life cycle costs: An organizational model. Journal of Cost Management (Fall): 39-51. (Summary).

Sinason, D.H. 1991. A dynamic model for present value capital expenditure analysis. Journal of Cost Management (Spring): 40-45. (Summary).