Chapter 6 Making Investment Decisions At the end of this chapter you will be able to Explain the ways in which investment can help businesses to reach functional objectives Select and use investment appraisal techniques Identify and apply appropriate investment criteria Assess the risks and uncertainties of specific investment decisions Evaluate quantitative and qualitative influences on specific investment decisions

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Setting the scene Read New beginnings at Chester Zoo Look at the discussion points and make notes Class discussion

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The importance of investment When we talk about investment we mean capital expenditure (spending on assets that will stay in the business in the medium to long term) Because investments mean spending large amounts the decisions are not taken lightly It is important because it will help to achieve objectives If a firm wants to grow it will need to invest in new machinery or larger premises Managers will also have to focus on maximising shareholder returns A business that wants to be the market leader is likely to have its own Research and Development (R&D) department Exam Tip – when assessing an investment decision you need to consider whether this investment will help the firm or function to achieve their objectives BT’s R&D campus

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Investment Appraisal There are 3 main techniques that we can use to assess whether an investment is worthwhile Payback Average rate of return (ARR) Net present value (NPV) All of these methods involve estimating the cash flows (seen directly from the investment) over the expected life of the investment Investment Appraisal – the process of analysing the financial merits of a possible future investment

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Payback A printing firm has decided to buy a new machine and needs to decide which machine to buy (A or B) We will use the payback method to decide Payback is a calculation of how long it will take to recoup the cost of an initial investment To make this calculation we have to know the cost of the machine (to buy and any ongoing maintenance costs) and the revenue we will gain from using this machine

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Payback If we look at Machine A first For all of our appraisal methods we need a cash flow table It must always start with year zero (not 1!) In year 1 we can see that we have cash going out of £7,500 and cash coming in of £150,000 This is a net cash flow of £142,500 If we look at the cumulative cash flow we can see that somewhere between years 3 and 4 we will cover the costs of the machine Year Cash out Cash in Net cash flow Cumulative net cash flow 0 £750,000 £0 -£750,000 1 £7,500 £150,000 £142,500 £142,500 2 £7,500 £200,000 £192,500 £335,000 3 £7,500 £260,000 £252,500 £587,500 4 £7,500 £260,000 £252,500 £840,000 5 £7,500 £300,000 £292,500 £1,132,500

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Payback On top of the 587,500 (year 3) we need an additional 162,500 (750,000 – 587,500) This would take 162,500/252,500 x 12 months 7.7 months which we round up to 8 months In total it will take 3 years and 8 months to payback the loan Calculate the payback for machine B (P40) Year Cash out Cash in Net cash flow Cumulative net cash flow 0 £750,000 £0 -£750,000 1 £7,500 £150,000 £142,500 £142,500 2 £7,500 £200,000 £192,500 £335,000 3 £7,500 £260,000 £252,500 £587,500 4 £7,500 £260,000 £252,500 £840,000 5 £7,500 £300,000 £292,500 £1,132,500

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Payback The shorter the payback the less risk is involved in the project and the quicker the firm can start making a profit from its investment It is a good method because it is simple It is particularly good to do if the investment is being funded by external finance (you would be able to work out the term of the loan) The disadvantage is that it Ignores cash flow after the year of payback It ignores the overall profitability of the project It assumes that in the year of the payback the inflow of cash will be steady (for many firms this will not be true) This method of appraisal is rarely used on its own – it will be used in conjunction with others such as ARR or NPV

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Average Rate of Return This assesses the worth of an investment by calculating the average annual profit as a percentage of the initial investment Calculate the average annual profit by adding up all the cash flows and dividing by the number of years Average Rate of Return = Average Annual profit x 100 Initial Investment Calculate the ARR for Machine B Year Cash out Cash in Net cash flow Cumulative net cash flow 0 £750,000 £0 -£750,000 1 £7,500 £150,000 £142,500 £142,500 2 £7,500 £200,000 £192,500 £335,000 3 £7,500 £260,000 £252,500 £587,500 4 £7,500 £260,000 £252,500 £840,000 5 £7,500 £300,000 £292,500 £1,132,500 Total £382,500 Average annual profit £76,500 Average rate of return 10.2%

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Average Rate of Return The higher the ARR the more potentially profitable the investment The good thing about this appraisal tool is that it can be used to make comparisons between different types of investment projects It can also be compared to ROCE – how does it compare with the current return on capital employed? The disadvantage is that it does not take into account the timings of the cash inflows – if the majority of the cash flow came in late in the project the profit would still be the same This is why it would be used in conjunction with payback It also does not take into account inflation which is why NPV can be used

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Net Present Value (NPV) Because of inflation £1 today will buy more today than it will in a few years and We are not taking into consideration the fact that if we put the money in the bank the money would earn interest and would grow in value each year This means that the cash flow table does not give us an accurate value of cash flows i.e. what they will be worth today To give them their correct value we use a discount factor Firm’s will use different discount factors for different investment projects You don’t need to worry about what discount factor to use as it will be given to you Each net cash flow figure is multiplied by the discount factor to give the net present value of that cash flow – how much it is worth today

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Net Present Value (NPV) We then add all the NPVs to calculate the net cash gain from the project expressed in today’s term If the Net Present value is positive then the project should be accepted If two projects are being selected the one with the highest positive NPV should be chosen If the present values of future cash inflows is less than that of the outflows there will be a negative NPV and the project should be rejected

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Net Present Value (NPV) Advantages gives managers a very easy guide that they can use to decide whether or not to go ahead with an investment takes into account the time value of money (recognition that £1 today will be worth less in the future). The other two methods do not do this Disadvantages Does not take into account speed of repayment of the original investment It can be difficult to decide which discount factor to use Complete both activities on P42

Investment criteria A firm is likely to give its managers a set of investment criteria This is a predetermined target against which to judge an investment These will be minimum levels that have to be reached before it is accepted This prevents bias in decision making The criteria will depend on the nature of the business and the investment and also the culture of the business (are they risk averse) An example of criteria Payback of 5 years or less ARR 3% above interest rate NPV positive with shortest payback period

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Risks and uncertainties Investment decisions carry with them risk The gain that is achieved from that risk is the reward If the ARR is higher than the bank interest the higher return is the reward The degree of risk will depend on The amount of money required and the source The time committed to the project The impact on funding in the rest of the business The ease with which the project can be reversed The impact of the choice on other future strategic choices

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Risks and uncertainties There is uncertainty because estimates of future costs and revenues have to be made and estimates are not always correct The degree of uncertainty associated with a project depends on The stability of the market – will the forecasts be accurate? The credibility of the source of the estimated costs and revenues The stability of the economy Potential competitor reaction to the investment The overall time period of future projections

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Qualitative influences Decisions will not only be based on numbers Managers will think about Whether the investment is ethical How it will affect worker motivation What consumers will think How it will affect society Will it negatively affect the brand A decision on whether to relocate manufacturing abroad may look good financially but will mean redundancies, negative publicity and exploitation of cheap labour sources

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Case Study Lowfare Airways plc P44 Answer all questions Complete Summary Questions Learn the key terms To be completed for homework by …………..

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