Making Investment Decisions

Investment is used in relation to capital expenditure. I,e the purchase of assets that wil stay in the business in the medium to long term.

Investments involve spending substantial sums od money.

Managers do not take investment decisions lightly as there is no such thing as a risk free investment and all investments have both financial and opportunity costs.

It is through investments that a business will strive to achieve its objectives.

Similarly, when weighing up the financial merits of an investment, managers will have to focus on the objective of maximising shareholder returns. A business with the objective of being market leader is likely to have an ongoing investment in the most up to date machinery or extensive R&D

Investment appraisal: the process of analysing the financial mertis of a possible future investment

Techniquies are scientific decision making tools.

Quantative results should be considered alongside the qualitative factors.

Payback, average rate of return and net present value.

These three techniques all involve estimating the total cash outflow and cash inflows over the expected life of an investment.

Payback: calculation of how long it will take to recoup the cost of an investment.

Payback evaluates individual investment projects in terms of the time taken to recover the outlay

First           Add up the net cash flow for the project until you have enough to cover the initial investment.

Second   Calculate the amount still needed for machine A in the year of payback and divide by the net cash inflow for that year and multiply by 12 to calculate the month of payback

The shorter the payback period, the less risk involved in the project and the quicker the business can start to generate profit from its investment. 

Payback is the most commonly used form of investment appraisal because of its simplicity. 

Very important to businesses with potential cash flow problems. (Liquidity) or if the investment is in technical equipment which is likely to become obsolete or out of date quickly.  is important to highly geared firms.

It fails to take into account any inflows after payback and ignores the overall profitability of the project. assumes that in the year of payback the cash inflow is steadily spread across the year. 

ARR: average annual profit expressed as a percentage of initial investment

First                      Calculate average annual profits by adding up all the net cash flows divided by a number of years

Second             Divide the average annual profit by the initial investment and express as a %

The higher the ARR, the more potentially profitable the investment.

it allows for easy comparison with alternative forms of investment, such as the interest rate offered by a bank. Can also be compared to current of target ROCE

It does not take into account the timing of cash inflows, an investment may seem very profitable but if it takes four years before a positive net cash flow is achieved then this might pose too great a threat to the short term survival of a firm.

Net Present Value: the total net return of an investment stated in today’s monetary value

 £100 received today is more than £100 received in the future. If the £100 received today was invested in the bank, it would grow in value each year.  This is done by use of a discount factor

Discount factor: the rate by which future cash flows are reduced to reflect current interest rates

First                       Multiply each year’s net inflow by the relevant discount factor to calculate NPV

Second              Add up all the NPVs to calculate the net cash gain from the project expressed in today’s terms.

If the project has a positive NPV then it should be accepted. The higher the NPV the better. ‘positive accept, negative reject’ provides managers with a simple rule for decision making.

Takes into account the time value of money.

It doesn’t account for the speed of repayment, can be difficult to choose the right discount factor and non financial managers may find the concept hard to understand. 

Investment criteria: a pre-determined target against which to judge an investment

 These are minimum targets, known as criterion levels, that a possible investment must be able to reach before it is accepted.

By setting criterion levels in advance, it gives a clear rule on what is or is not an acceptable investment and prevents bias in decision making.

The specific criteria set will depend upon the nature of the business and the investment. It will also be influenced by the culture of the organisation, whether one of risk taking or risk aversion. 

The degree of risk associated with a project will be dependant on a number of factors. Key points to consider will include:

·         The sum of money to be invested as well as the source of that money

·         The length of time the business must commit to the project

·         The impact of the investment on other aspects pf the business, for example day to day funding.

·         The ease or difficulty with which teh investment can be reversed.

·         The impact of the decision on other strategic choices

The degree of uncertainty associated with a project will be based upon a number of key factors. Key points to consider ill include:

·          The stability of the market and associated likely accuracy of sales forecasts

·          The credibility of the source of the estimated costs and revenues

·          The stability of the economic environment in which the business operates

·          The potential competitors’ reactions to the investment

·     The overall time period of future projections. 

Include the impact on the image of the firm, the workers, ethical considerations, consumer perceptions and the impact on wider society. 

Analysis Calculating and interpreting data using investment appraisal, Examining the implications of the results of these calculations, Examining the advantages and disadvantages of each of these techniques within a specific context, Analyzing non financial factors that might affect investment decisions.

Evaluation Judging how applicable certain techniques of investment appraisal are in given circumstances, Evaluating the relative importance of financial and non financial factors in reaching decisions regarding investment projects, Assessing investment decisions in the context of scenarios and a range of financial and non financial factors.

Links Human resource planning- human implications of investment decisions. Marketing- does a demand exist for products that might be produced as a result of the investment. Economic environment