Making Investment Decisions

  • Created by: Soph
  • Created on: 04-06-14 12:38


  • 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


  • Contemplating introducing new products
  • Contemplating the purchase of a fixed asset
  • Investing technology
  • Spending on a promotional campaign or brand
  • Retraining the workforce
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Financial Techniques for Making Investment Decisio

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


  • 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
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Payback and ARR


  • 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
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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


  • 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
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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
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Investment Criteria

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
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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
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Its Worth

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
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Qualitive Influences on Investment Appraisal:

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