Making Investment Decisions (Part 1)

You should now be able to:

1. Understand the ways in which investment can help businesses to reach functional objectives

2. Select and use investment appraisal techniques

3. Interpret investment appraisal findings

Learning Objectives

Why is investment so important?

Complete the missing words to find out.

Finished? Complete the key

terms boxes.

Investment Appraisal

What is investment appraisal?

Is the process of analysing whether a capital investment is worthwhile, or if there are a number of options, which one is the best investment.

A firm will want to know:

1. How long will it take to get our money back? If invest £400,000, can we expect to get that money back within the 1st year or could it take fours years?

2. How profitable will the investment be? What profit will be generated per year by the investment?

Investment Appraisal

There are three investment appraisal techniques:

Payback Average rate of return Net present value

Payback

The payback method calculates the length of time it will take to pay back the initial cost of the investment.

This is done by first calculating the year in which the cost will be paid back and then calculating the month in which it will be paid back.

Pay back – Step 1

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

(y1) £142,000 + (y2) £192,500 + (y3) £252,500 = £587800(y1) £142,000 + (y2) £192,500 + (y3) £252,500 + (y4) £252,500 = £840,000

This means that by Year 4 enough money has come in from the investment to cover the initial investment of £750,000. Payback is therefore three years and x months.

Pay back – Step 2

Calculate the amount still needed for Machine A in the year of payback (y3) and divide by the net cash inflow for the following year (y4) and multiply by 12 to calculate the month of payback.

£750,000 Cash investment minus £587,800 cumulative net inflow at end of year 3 = £162,200.

Remaining cash required: £162,200 x 12 = 7.7 months, rounded up to £252,500 8 months.

The shorter the payback period, the less risk there is involved in the project and the quicker the business can generate profit from it’s investment.

Most commonly used form of investment appraisal due to simplicity.

Important for firms with cash-flow problems.

Important for firms with technical equipment that can go obsolete or out-of-date quickly.

Payback important if paid for through external finance.

Disadvantage – fails to ignore the overall profitability of the project and also assumes that cash flow will be steady.

Payback – Key Points

Calculate the Payback for Machine B.

Based on the payback method, which do you think represents the better investment?

Your turn!

Average Rate of Return (ARR)

ARR assesses the worth of an investment by calculating the average annual profit as a percentage of the initial investment.

ARR – Step 1

Calculate ARR by adding up all the net cash flows divided by the number of years.

Annual average profit = Total net cash flow Number of years

Total net cash flow for Machine A = (y0) (£750,000) + (y1) £142,000 + (y2) £192,500 + (y3) £252,500 + (y4) £252,500 + (y5) £292,500 = £382,500

Average annual profit = £382,500 = £76,500 5

ARR – Step 2

Calculate ARR for Machine A by dividing the average annual profit by the initial investment and express as a percentage:

Average Rate of Return = Average annual profit x 100 Initial investment

Average Rate of Return = £76,500 x 100 = 10.2% £750,000

The ARR for Machine A is 10.2%

The higher the ARR the more potentially viable the investment.

The advantage of ARR is that it allows for easy comparison with alternative forms of investment, such as interest rates offered at a bank or compared to ROCE.

Disadvantage – it does not take into account the timings of the cash flow inflows. An investment may seem profitable but it may take four years for a positive cash flow to be achieved.

ARR – What does it mean?

Calculate the ARR for Machine B.

Based on the payback method, which do you think represents the better investment?

Your turn!

Easy to calculate and understand

Advantage - Payback

Financial Strategy?

Provides no insight into profitability.

Disadvantage - Payback

Financial Strategy?

Takes the opportunity cost of money into account.

Advantage - ARR

Financial Strategy?

Ignores what happens after the payback period.

Disadvantage - Payback

Financial Strategy?

Complex to calculate and communicate.

Disadvantage - ARR

Financial Strategy?

Important for a business with a weak cash flow; it may only be willing to invest only in projects with quick payback.

Advantage - Payback

Financial Strategy?

The meaning of the result is often misunderstood.

Disadvantage - ARR

Financial Strategy?

Re-cap Learning Objectives

You should now be able to:

1. Understand the ways in which investment can help businesses to reach functional objectives

2. Select and use investment appraisal techniques

3. Interpret investment appraisal findings