Making Investment Decisions

• If a firm wishes to grow it needs to invest
• The purchase of all/part of a firm, fixed asset or major expenditure
• Action involves a degree of risk judged against the likely return

When:

• Contemplating introducing new products
• Contemplating the purchase of a fixed asset
• Investing technology
• Spending on a promotional campaign or brand
• Retraining the workforce

Firms use a series of techniques to forecast costs and likely returns. The techniques depend on:

• All costs/revenues can be forecast easily and accurately
• Key variables will not change
• Firm is seeking maximum profits

Considerations:

• Total profit earned by the investment over the foreseeable future
• How quickly the investment will recover its costs

The process of assessing of these factors is investment appraisal

Forecasts can become inaccurate because:

• Competition act unexpectedly
• Tastes and fashion change
• Economy changes

Payback:

• Measures the time period required for the earnings from an investment to recoup its original cost
• It’s a quick and simple process
• Ignores the level of profit and the timing of any receipts

 Average Rate of Return:

• Calculates percentage rate of return on each possible investment
• The returns may be as forecastIt considers the level of profit earned from an investment and allows from comparison
• Fails to differentiate between high return, quality and long profitability

Discounted Cash Flow:

• Takes into account what is termed the ‘time value of money’
• Based on the principle that present money is worth more now than at some future point
• Having money now is certain, having the same amount later on isn’t; the opportunity cost is the money could have put into an interested bearing account
• The longer the delay before money is received, the lower its value in present day terms

Discounting:

• Adjusting the value of many received at some future date to its present value
• Based upon interest rates at current time of value
• Discounting rate selected normally reflects the interest rates that are expected for the duration of the project

Net Present Value:

Discounts expected future cash flow is the basis of calculating net present value. If a negative value is created the investment isn’t worthwhile.

Comparison of Appraisal Methods:

• Payback is easy to calculate and understand, but it ignores the timing of payments and excludes income received after the payback
• Average Rate of Return measures the profit the achieved and allows for easy comparison, but also ignores the timing of payment and only calculates an average
• Discounted Cash Flow makes an allowance for opportunity cost and takes into account cash inflows and outflows, but choosing the discount rate is hard and it is a complex method to calculate

The Rate of Investment:

• Average rate of return produces a figure that can be compared with the interest rates set by the Bank of England
• Firms will seek a return greater than the set interest rates
• Many investments are long term and thus the interest rate will have fluctuations

Level of Profit:

• It’s not unusual for a firm to set itself targets in terms of return on capital employed
• Investment projects should generate that at least matches the firm overall ROCE target

Alternative Investment:

Firms consider a selection of investments before picking one

• Opportunity cost
• The firm will probably simply select the project which performs best subject to criteria

Risk is the chance of something adverse or bad happening

Difficulties with forecasting:

• Harder to forecast sales many years into the future
• When entering a new market, the firm has no experience or records to us as a guide
• The change will bring in new competitors in some way

Costs may rise above the forecast level, reducing the returns

 Managing Risk:

• Purchasing raw materials on forward markets to keep a fixed price
• Build in the potential for fluctuations in sales, revenue and costs to allow flexibility
• Ensuring the firm has sufficient funds to cover adverse results

It’s worth:

• Results are only as good as the data they are based on
• It is possible to make an allowance to represent risk by potentially reducing cash inflow or increasing costs
• A modern approach is to use probability to make more accurate predictions
• Uncertainty is not measureable and cannot be included in numerical techniques and thus may make an investment appraisal useless
• Without the use of Payback, managers would operate on the basis of hunch and guesses
• As market becomes more complex and global and the need for investment appraisal becomes greater as the detailed research for forecasts

• Corporate image
• Corporate objective
• Environmental and ethic issues
• Industrial relations