Investment Decisionmaking Content Investment Issues with investment appraisal

Investment Decision-making

Content • Investment • Issues with investment appraisal • Investment appraisal techniques: – Payback – Average Rate of Return (ARR) – Discounted cash flow (NPV) • Qualitative factors affecting decisions:

Investment • Investment refers to the purchasing of productive capacity or capital expenditure • Capital expenditure – Spending by a business to buy fixed assets e. g. property, vehicles etc

Why invest? • Businesses need to invest to grown • They might want to increase capacity so they can produce more • If they produce more then they can sell more and increase sales revenue • They could also look to invest to increase the efficiency of their operations

Investment Appraisal • Looks at whether an investment project is worthwhile or not • Can be used for all types of investment from the purchase of a new piece of machinery to a whole factory • It allows managers to make an informed choice regarding the viability of the project

Financial techniques of investment appraisal • These are all based on a number of assumptions: – All costs and revenues can be forecast accurately for future years – Key variables like interest rates will not alter – That the business will be looking to maximise profits

Problems with Forecasts • There may be problems with forecasts because: – Competitors could bring out new products / change prices altering sales and revenue – Tastes and fashions may change causing an unexpected slump in demand – The economy may change either upwardly or downwardly – recession or boom – Costs can be affected by inflation and import prices

Investment Appraisal • Types of investment appraisal: – Payback Period – Accounting Rate of Return (ARR) – Net Present Value (discounted cash flow) – Discounted cash flow

Investment Appraisal • The idea is that if you invest in the future you will have more incomes coming into the business • Investment appraisal methods look at the comparison of the future incomes with the cost of the initial investment

Payback Method • This looks at how long it takes to pay back the initial cost of the investment • Need to know how much revenue the asset will generate • For example if a machine costs £ 50, 000 and it produces items 50, 000 items that retail for 50 p each it will take 2 years to payback the initial investment

Payback method • This allows you to compare projects – which one takes the shortest time to payback the initial investment • It can take an investment less than a year to generate revenues that cover its cost

Advantages and Disadvantages of Payback Advantages • Easy and simple to use and understand • Good if you just want a quick rate of return Disadvantages • Doesn’t look at timings of payments • Doesn’t look at incomes received after payback • Profit isn't calculated

Average Rate of Return • Looks at the profit generated by the investment compared to the cost of the investment Average profit • ARR = ---------------------- x 100 Initial cost of investment • This gives the business a % figure showing the average rate of return • Businesses can then compare this figure to how much they would get with alternative investments

Advantages and Disadvantages of ARR Advantages • Looks at profits • Easy to compare with other methods of investment e. g. putting money in the bank Disadvantages • Only looks at average profits • Doesn’t look at timings of payments

Discounted cash flow • This considers what money will be worth in the future • Discounting – reduce value of future earnings to reflect opportunity cost of an investment • Reasons why this exists: – Risk – Opportunity cost

Net Present Value • One way of discounting cash flow is looking at NPV • This method takes into account inflationary pressures and interest rates • The idea that the money increases in value • Looks at how much you would need to invest now to earn a certain amount in the future • Allows comparison of an investment by valuing all cash inflows from the investment at the present value • You can compare what would happen if you invested the money in other projects or just saved it in the bank

Net Present Value Future Value PV = --------(1 + i)n Where i = interest rate n = number of years • Cash flow x discount factor = present value • Present Values can be found through valuation tables

Discounted cash flow – Advantages and Disadvantages Advantages • Looks at the opportunity cost of investing • Considers cash inflows and outflows for the lifetime of the investment Disadvantages • Can be difficult to choose the right discount rate • Is very complex

Qualitative techniques of investment appraisal • As well as financial methods firms need to consider: – Corporate image – you may reject an investment opportunity as it will reflect badly on your business – Corporate objectives – also have to judge if the investment is aligned to your corporate objectives – Environmental and ethical reasons – is the investment environmentally and ethically sound – Industrial relations – what is the impact on the work force – does it decrease jobs?

Summary • Investment is the process of purchasing fixed assets in order to increase capacity / productivity • Investment appraisal techniques aim to assess the financial feasibility of investment options • Investment appraisal techniques are based on a number of assumptions which may not be true • Payback method looks at how long it will take to pay back the cost of the initial investment • Average rate of return looks at the percentage rate of return on the investment • Discounted cash flow (NPV) looks at the present values of any future revenues from the investment • Qualitative factors affect investment decisions including corporate image, objectives, industrial relations and environmental and ethical reasons