Business Finance – Investment And Decision Making

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Emma Rudd
Finance and Accounts
Investment Decision Making
Investment is an important term and often entails managers taking major decisions.
Investment can mean a decision to purchase part or all of another business, perhaps as a
result of a takeover bid. However it is perhaps more common to use the term in relation
to the purchase of a fixed asset or some other major expenditure. What is common is
that all such actions involve a degree of risk. This must be judged against the likely
return. The final decision will depend upon manager's assessment of these two factors.
Businesses take decisions regarding investment in a variety of circumstances.
When Contemplating Introducing New Products
A business may assess the likely costs and returns from investing in one or more
new products.
Evaluating whether or not to invest in new fixed assets as part of a planned
programme of growth.
Investing in New Technology
this is often undertaken to reduce costs and improve productivity.
Techniques of Investment Appraisal
Businesses may also use techniques of investment appraisal before spending
heavily on promotional campaigns, developing new brands or products or
retraining the workforce.
In each circumstance's, however, the business must adopt an appropriate appraisal
technique to decide whether the returns received from an investment are sufficient to
justify the initial capital expenditure.
Financial Techniques of Investment Appraisal
A number of techniques are available to managers to assist them in taking decisions on
whether to go ahead with investments, or to help in making a judgement between two or
more possible investment opportunities. This section will look at three of the most
important of these techniques: payback, the average rate of return and discounted cash
These financial techniques are valuable but do depend upon a number of assumptions
All costs and revenues can be easily and accurately forecast for some years into
the future
That key variables (e.g. interest rates) will not change
That the business in question is seeking maximum profits.
There are two major considerations for managers when deciding whether or not to
invest in a fixed asset or another business.
1. The total profits earned by the investment over the foreseeable future.
2. How quickly the investment will recover its cost. This occurs when the earnings
from the investment exceed the cost of the investment.
The process of assessing these factors is called investment appraisal and refers to the
process of assessing one or more potential investments. Forecasting future costs and
revenues can be a very difficult and at times expensive exercise to undertake.
Forecasts about future revenues could prove to be inaccurate for a number of reasons.
Competitors may introduce new products or reduce their prices, reducing
forecast sales and revenues.

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Emma Rudd
Tastes and fashions may change resulting in an unexpected slump in demand.
The economy may move into recession or slump (or alternatively into an upswing)
resulting in sales figures radically different from those forecast.
Costs can be equally tricky to forecast. Unexpected periods of inflation, or rising
import prices might result in inaccurate forecasts of expenditures. This can lead to a
significant reduction in actual profits when compared with forecasts.…read more

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Emma Rudd
forecast. Therefore it is important that such an investment earns significantly more
than the rate of interest available from banks etc. If the percentage return was
identical to that on a high-interest account in a building society, then the building
society would represent the better investment as there's no risk involved.
Always take the shortest length of time
Calculating the Average Rate of Return
Total Net Cash Flow ­ Cost of Investment = ??? / No.…read more

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Emma Rudd
Discounting is the process of adjusting the value of money received at some future date
to its present value ­ i.e. it's worth today. The rate of interest plays a central role in
The choice of interest rate to be used as the basis for discounting is an important
decision by a business undertaking investment appraisal. The discount rate selected
normally reflects the interest rates that are expected for the duration of the project.…read more

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Average Rate of Return Measure the profit Ignores the timing of
achieved on projects payments
Allows easy Calculates average
comparison with profits ­ they may
returns on financial fluctuate during the
investments e.g. bank project
Discounted Cash Flow Makes an allowance Choosing the discount
for the opportunity rate is difficult ­
cost of investing especially for long
Takes into account term projects
cash inflows and A complex method to
outflows for the calculate and easily
duration of the misunderstood.…read more


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