Introduction
Investment appraisal is a strategic decision-making process for determining how a firm’s management should allocate limited capital resources to long-term investment opportunities. Investment decisions will not be made in isolation from other business decisions and plans; the question of strategic fit arises. Accordingly, investment decisions should be made in the context of the firm’s strategic business plan, with the goal of maximizing the long-term market value of the firm and the realization of its strategic objectives. The investment decision-making process involves identifying, evaluating and implementing long-term investment opportunities which will enhance shareholder wealth and achieve the firm’s objective ( 1999).
The costs and benefits of these investment opportunities will be spread out over time. Because the outcome of long-term investment decisions, more so than any other type of business decision, will directly affect the firm’s future and its value, it is vitally important that investment proposals are properly evaluated before they are implemented. The essence of investment is to forego present consumption of resources in order to increase the total amount of resources which can be consumed in the future. The objective of an investment decision is to acquire an asset for less than its value, this way corporate or personal wealth can be increased. Acquiring an asset for at least its value will maintain wealth or value. It would not make good financial sense to acquire an asset for more than its value as wealth would be eroded (1999).
From the corporate firm’s point of view the financial manager’s objective should be to invest in projects which add to corporate and shareholder value. The problem is that at the outset it is often difficult to determine which assets or projects will be wealth enhancing and which will be wealth reducing. All the more reason people should employ good appraisal techniques and procedures to help us make the right choice. For a wealth-maximizing business enterprise, the most common form of investment is in real corporate assets. Such assets are clearly very important since, for most firms, they represent the largest financial investment and are the key earning assets of the firm. In business, investment decisions are made for many reasons, but although the motives may differ, the techniques used to evaluate them are essentially the same (1999).
Typically investment proposals may be motivated by one or more of the following: First motivation is Competitiveness. New investment may be required to improve the firm’s competitive position and gain competitive advantage. Second motivation is Expansion and growth. New/additional facilities or operating capacity may be needed to meet increases in activity and sales. Third motivation is Replacement. Due to advances in technology and operating methods old equipment and buildings may need to be replaced. Fourth motivation is Renewal. Rebuilding, overhauling or refitting existing buildings and equipment may be necessary to improve operating efficiency, to comply with legislative requirements and/or to improve quality standards. Fifth motivation is Acquisitions and mergers. A firm may seek opportunities to grow by acquiring another suitable company. The last motivation is Foreign direct investment (FDI). There may be opportunities to grow by building a factory or acquiring a company in a foreign country ( 1999). The paper will discuss about portfolio framework for investment decisions in the context of global financial markets. The paper will also discuss about how investors can use historical data on international stock market returns.
Global financial markets
Within the neo-classical paradigm, capital flows where its marginal product is higher. As a result, the allocation of capital is more efficient and global welfare is higher when capital flows freely across national borders. As trans-border capital flows increase, economies are progressively integrating globally. The financial structures of economies as well as the world of finance are changing. This applies to both domestic and global financial markets. A quarter century ago, a businesswoman was restricted to borrowing from her domestic market. However, if she operates in an emerging market economy, several options are presently open to her. For instance, she can choose between issuing stocks and bonds in the domestic or foreign financial markets ( 2004).
She can reduce her cost of capital if foreign currency loans are available at more attractive terms than the domestic loans, and these loans can be hedged by using a variety of financial products. She can also consider selling equity at foreign Bourses, which are far more liquid than the domestic ones. A functional definition of financial globalization is the integration of the domestic financial system of an economy with the global financial markets and institutions. The enabling framework of financial globalization essentially includes liberalization and deregulation of the domestic financial sector as well as liberalization of the capital account. In a globalized financial environment domestic lenders and borrowers participate in the global markets, and utilize global financial intermediaries for borrowing and lending. Trans-border capital flows tend to integrate the domestic and global financial markets and systems ( 2004).
Although the global financial markets remained in a state of flux throughout the twentieth century, transformations since the early 1970s have been nothing short of dramatic. The Global forces for change included advances in information communication technology (ICT), making remote access to trading systems ubiquitous. Also, innovations in ICT and the development of new instruments in the financial market became self reinforcing. Furthermore, financial deregulation and liberalization at the national level, opening up to international competition, and globalization of financial and real markets, were significant change agents ( 2004).
Additionally, changes in corporate behavior, such as growing disintermediation and increased shareholder pressure for financial performance, were the prime movers behind the transformation in the financial services sector in the emerging market economies. Advancing globalization during the 1980s and the 1990s increased trans-border capital flows and tightened the links between financial markets in the emerging markets and global financial centers. Growth of global financial markets was further accelerated by improvements in the fundamentals, particularly by more rapid economic growth in the emerging market and matured industrial economies. It was also assisted by economic and structural reforms in the emerging market and transition economies. Lastly, the recent spate of banking and financial crises has accentuated the pressures for transformation. Notwithstanding the recent decline in capital flows, the evidence of the preceding quarter-century suggests that financial markets in the emerging market economies have become increasingly deep and resilient ( 2004). The state of global financial markets changes as different things happen in the environment. The global financial markets are affected by different situations such as increase or decrease of the interest rates. It is also affected by improvements in the society, such as new trends in different industries.
Stock market returns
Nominal returns are unadjusted for inflation. Real returns are corrected for inflation and are thus a more accurate reflection of the growth in an investor’s purchasing power. Because the goal of investing is to accumulate real wealth an enhanced ability to pay for goods and services the ultimate focus of the long-term investor must be on real, not nominal, returns. In the stock market’s early years, there was little difference between nominal returns and real returns. In the first period, from 1802 to 1870, inflation appears to have been 0.1 percent annually, so the real return was only one-tenth of a percentage point lower than the nominal stock market return of 7.1 percent. Inflation remained at an extremely low level through most of the nineteenth century. In the stock market’s second major period, 1871 to 1925, returns were almost identical to those in the first period, although the rate of inflation accelerated sharply in the later years ( 1999). Nominal stock market returns compounded at an annual rate of 7.2 percent, while the real rate of return was 6.6 percent. The difference was accounted for by annual inflation averaging 0.6 percent. In the modern era, the rate of inflation has accelerated dramatically, averaging 3.1 percent annually, and the gap between real and nominal returns has widened accordingly. Since 1926, the stock market has provided a nominal annual return of 10.6 percent and an inflation-adjusted return of 7.2 percent ( 1999).
Since the Second World War, inflation has been especially high. From 1966 to 1981, for example, inflation surged to an annual rate of 7.0 percent. Nominal stock market returns of 6.6 percent annually were in fact negative real returns of -0.4 percent. More recently, inflation has subsided. From 1982 to 1997, during substantially all of the long-running bull market, real returns averaged 12.8 percent, approaching the highest return for any period of comparable length in U.S. history. The high rate of inflation in the modern era is in large part the result of nations switch from a gold-based monetary system to a paper-based system. Under the gold standard, each dollar in circulation was convertible into a fixed amount of gold. Under the modern paper-based system, in which the dollar is backed by nothing more than the public’s collective confidence in its value, there are far fewer constraints on the U.S. government’s ability to create new dollars. On occasion, rapid growth in the money supply has unleashed bouts of rapid price inflation. The effect on real long-term stock returns has nonetheless proved neutral. Even as nominal returns have risen in line with inflation, the rate of real return has remained steady at about 7.0 percent, much as it did through the nineteenth century ( 1999).
Different variables determine stock market returns over the long term this includes the dividend yield at the time of initial investment; the subsequent rate of growth in earnings; and the change in the price earnings ratio during the period of investment. The total of these three components explains nearly all of the stock market’s returns over extended holding periods. By analyzing the contribution to total return of the three factors, reasoned consideration of future returns can take place. The initial dividend yield is a known quantity. The rate of earnings growth has usually been relatively predictable within fairly narrow parameters. And the change in the price earnings ratio has proven highly speculative. Total return is simply the sum of these three factors. For example, an initial dividend yield of 3 percent plus a forecasted earnings growth of 7 percent annually over the next 10 years would bring the return to 10 percent. A change in the price earnings ratio from 15 times at the beginning of the period to a forecasted 18 times at the end would add 2 percentage points to that total, bringing the return on stocks to 12 percent ( 1999).
Portfolio Framework for investment decisions
In investment decisions in the context of global financial markets; a portfolio Framework serves different kinds of purpose. The portfolio framework helps in determining what should be considered before making any investment decisions. The next figure will show the portfolio framework.
The portfolio framework describes that when investment opportunities come, decisions should not be hastily made. Different considerations have to be analyzed. One consideration is the profitability of the investment. When one wants to engage in an investment, there should be assurance that the investment will be profitable so that investment will not be put into waste. Another consideration is the change in financial climate. The financial sector might be doing well in one instance but some other time it may be having some difficulties. Investing during a time of financial problems can cause a company or any individual lost opportunity. Lastly a consideration should be the longevity of the investment.
Using Historical Data on international stock market returns
Investors can make use of historical data on international stock market returns as a means to predict the outcome of the stock market return. Through the historical data the different trends in the stock market can be observed and then the possible outcome can be predicted. The historical data on international stock market can also help in observing what causes the changes in the stock market and how often the said changes happen. The historical data on international stock market can help in analyzing specific information on the data such as the causes of the changes and the frequency of increase or decrease or stock market returns. Moreover the historical data on international stock market helps in determining the level of decrease or increase of the stock market returns.
Conclusion
In business, investment decisions are made for many reasons, but although the motives may differ, the techniques used to evaluate them are essentially the same. Growth of global financial markets was further accelerated by improvements in the fundamentals, particularly by more rapid economic growth in the emerging market and matured industrial economies. It was also assisted by economic and structural reforms in the emerging market and transition economies. The portfolio framework has described that when investment opportunities come, decisions should not be hastily made. Different considerations have to be analyzed.
References
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