Challenges in Financial Analysis for Investment

The fundamental macroeconomic approach assumes that entrepreneurs invest with the aim of making a profit, which, in addition to creating value, increases employment and economic activities, thereby leading to an increase in welfare. Investors can either be start-up entrepreneurs or industrial manufacturers and traders. Regardless of who they are, those who want to make data-driven decisions must inevitably use Weighted Average Cost of Capital (WACC) and Internal Rate of Return (IRR) in their basic analyses.?

?WACC calculates the average financing cost of a company's debt and equity capital, while IRR is the discount rate that equates the present value of future cash inflows and outflows of an investment to zero. Roughly speaking, if your investment's IRR is greater than WACC, meaning you expect a return better than your financing cost, it is financially sensible to make the investment.

However, the key issue lies in accurately forecasting these expectations. As seen in both calculations, it is essential that the estimates for future financing costs and inflation are not significantly off. For large-scale investments, it is sometimes necessary to estimate cash inflows for the next 20 years and predict the inflation and financing costs of that period to make today's investment decision.

In recent years, widely occurred excessive fluctuations in both inflation and financing costs, along with uncertainties in expectations for these two variables, have made WACC and IRR calculations almost meaningless. For instance, while it was possible to borrow in USD at around 4% 24 months ago, last year we witnessed it exceeding 10% for many debtors even developed markets. At the moment, every institution's estimate of what this cost will be next year varies. Similarly, inflation, both in developed and developing countries experienced high fluctuations. Expectations for next 12 months are also quite broad for many currency zones. These estimates are still relatively ceteris paribus expectations, excluding political risk factors for the relevant geographies.

?For instance, in analyzing a 30-year build-operate-transfer highway project today, you can claim that it is either a very profitable or a very unprofitable investment project by changing the assumptions about inflation and financing costs. To give a shorter-term example, you can prove that a machine you plan to use for eight years is very reasonable or the opposite from the company's perspective by changing the estimates in the analyses. No one can claim that these changes are "unrealistic" because the amplitude of fluctuations in the recent past was high enough to cover all possible scenarios.

It is already very difficult to make long-term investment decisions considering various market and management risks. It requires putting the accumulated savings of many years or the external resources you have obtained by enduring high financing costs at risk. On top of all this, projections of inflation and borrowing costs can range from 0% to very high levels and this leave the investment decision to sentiments and its accuracy entirely to chance. Including also exchange rate risks and regulation change risks in tax and incentives brings further difficulties which is quite possible in the modern world full of trade and political disputes.

As aforementioned in the first paragraph, investing activity increases economic activities and welfare of societies which cannot be assumed as easy tasks. That’s why entrepreneurs merge from those who possess a high level of courage to face all these challenges and a strong appetite for risk to succeed and self-actualize regardless of the challenges of the era.