Table of Contents
In order to make the right decision in advising Mr. A the right place to invest his money, we have to analyze the possible returns of each investment, the risks involved and the terms of investment. According to Damodaran (2002), most investors make rapid investment decisions without necessarily considering the long-term financial goals. In this case, we will have to implement strategic investment decision making concepts. These concepts involve identifying, evaluating and selecting the most appropriate project among different proposals that are likely to have the best returns. According to Gitman and Joehnk (2011), it is important to get the right decision in the first instance, because in case the decision is successful, the investor leaps much in returns.
Strategic investment takes into consideration the cost benefit analysis. Investment analysts identify the spending proposals of an investor, quantifiable analysis of the incremental cash flows fitted. However, because the elements of qualitative issues cannot be fitted into the cash flow statements, the analyst has to understand the political and economic environment of the investment before making a decision. In traditional approaches to the strategic investment, the investor usually considers the payback period, the returns on investment, accounting rate of return, discounted cash flows, and residual income. However, these analysis tools have been criticized for the lack of strong grounds and for taking a narrow perspective. They also exclude nonfinancial benefits and inconsistent treatment of the inflation status (Leuthold, 2010). There are alternative methods of investment evaluation that involve an expanded financial analysis framework. Finkel and Greising (2010) championed the modification of traditional methods to account short term and long term investment goals.
Investment Analysis for Mr. A
- Need analysis
Mr. A is retiring from senior management of MNC Company in Singapore and has two children. Since he lost his job, he does not expect to have more income from the company other than perhaps the retirement benefits not mentioned. Apart from the school fees, there is no house rent to pay and his spouse is currently working. His needs analysis in the near future can be analyzed as follows:
|Year 1||Year 2||Year 3||Year 4||Year 5||Total|
|Rent||House fully purchased|
|Healthcare||Covered by insurance policy|
Therefore, the main expenditures of the family in the next five years are school fees for the two children, approximately SGD 370,000. On average, the five years will demand an annual expense of SGD 74,000 on school fees. Thus, before committing himself to long term investment, Mr. A has to keep an equivalent amount aside to cater for these needs. Otherwise, he has to make an investment decision that will issue returns on short term basis.
- Available funds for investment
According to Mr. A’s account, he has approximately SGD 1.5 million, gained from various sources as outlined below.
|Central Providence Funds savings||850,000|
|Personal cash savings||300,000|
The investor has no intention to wish to place back his earnings to central Providence Funds, buy direct annuities, listed stocks or unit trusts from any broker bank or investment group. The following are some of the investment proposals he considers.
Potential Investment Channels
- Kelly’s proposal in Bank X
Required: Place the funds at the bank for investment management. The funds grow at an average of 8-12%. The cash is invested in stocks, bonds and liquid investments in the following proportions
|Portfolio (1M)||Ratio||Stake||Lowest annual returns (8%)||Highest annual returns (12%)|
|Cash deposits and equivalents||10%||100,000||8,000||12,000|
|2nd (100,000) portions x 5||0||0|
|Cash deposits and equivalents||10%||50,000||4,000||6,000|
|Total annual returns||120,000||180,000|
From the analysis above, it can be concluded that Mr. A will receive minimum SGD 120,000 and maximum SGD180,000. It is assumed that all the money is invested; the first SGD 1 million and the rest in proportions of SGD 100,000. It is also assumed that the returns are payable on annual basis. In addition, it is assumed that the rates of return, presented by the bank, are not likely to be adjusted in the near future as they have remained the same for the last two decades. Judging from the need analysis table, Mr. A will have enough money to pay the SGD 74,000 needed for school fees and will have enough for other upkeeps. At the end of the five years period, Mr. A will benefit with a minimum of SGD 600,000 and maximum of SGD 900,000 in profits.
In this case, Bank X investment portfolio has a reduced risk to the investor due to diversification. The process of splitting the investment into four sectors ensures that in case one sector fails, the other will be left to pay the returns and earn income for the bank. However, due to the fixed terms of this investment, it is highly affected by the inflation. This means that the annual returns will be 4% less (i.e. 4-8%) percentage return.
- Lawrence investments in Company Y
This investment involves buying prime land in established urban towns in UK and other places at lower market rates. The company signs a 5 years contract with investors, guaranteeing a 20% term profit for the total amount invested. In addition, annual returns of 8% are payable quarterly through the investment tenure. Supposing Mr. A invests all his money in this project for the term of 5 years, his returns will be as follows.
|Amount invested||Returns (8% annual return)||Guaranteed 20% Return|
As in the first project in Bank X, Mr. A is able to invest his entire amount of money for a five-year term and enjoy annual benefits, sufficient to meet his yearly needs. By the end of the five-year period, Mr. A will benefit with an annual return, payable quarterly, totaling to SGD 600,000 and a guaranteed 20% return of SGD 300,000. However, this investment decision is also affected by an inflation rate of 4% per annum.
- Michael’s Investment in company Z
In this investment, the company signs a contract with the investor for a period of 3 years with a quarterly return of 3%. This implies that the annual return is 12%. The company deals with prospecting oil in North America and has proven track records. Assuming that Mr. A invests his entire savings in this investment, he will have the following returns by the end of the 3-year term.
|Amount invested||Returns (12%)|
In three years, Mr. A will have an income return amounting to SGD 540,000. If it was the five-year term of investment, the total returns would be SGD 900,000. Compared to the other two investments, this one has the best offer and it has a guaranteed return. Mr. A can opt to sign another 3-year term on his investment after the expiry of the first one.
Investment Risks Present
Using the economic life cycle hypothesis, we assume that individuals base their consumption rate on a fixed percentage, depending on their expected income in life (Jin, 2009). The 4% effect of inflation depends on the portfolio that the investor takes. Fixed income investor is affected by the inflation the most. This means that purchasing power of the investor will be reduced by the same rate as inflation.
Based on the investors analysis illustrated above, Mr. A has many investment channels and potential opportunities to invest in. The first investment at bank X appears lucrative, but due to the number of risks involved in the stock market, fluctuation of currency and inflation, such investment would not be viable for him. In the second proposal, Company Y appears to have considered all possible development projects in the area before purchasing the land. This is the reason why it has been able to sustain itself in the industry. This idea is better than the first one, but the rate of return is still low, considering the investor’s personal needs and inflation rate because the stock (land) keeps on appreciating. The last proposal appears to be the most appropriate, because the returns are high and the risks are low. In addition, the company pays returns to the investors on a quarterly basis, which enables them to enjoy their benefits even before the investment term matures.