PART E – POOR INVESTMENT DECISIONS

AS 91381 (3.3)Apply business knowledge to address a complex problem in a given global business context

Investment refers to the purchase of capital goods or any other use of retained profits that is likely to earn a return in the future.  Investment is not the same as saving money in a bank or buying shares to try to earn dividends.

Investment is the purchase of productive capacity. For example, buying equipment or a new factory to increase capacity, meaning to increase the amount that can be produced. This will lead to consumer demand being met and sales revenue being generated.  Capital investments are usually long-term and expensive. Investment examples include:

O To replace obsolete, broken or worn-out machinery and equipment

O To add extra production capacityO To support the introduction of

new products and production processes

O To implement improved IT systems

O To comply with changing legislation and regulations

An investment decision should consider quantitative factors, such as forecasted cash flows and the profits to be generated. The investment should either increase revenue or reduced costs in the long-term. Qualitative factors will also influence a firm’s decisions about capital investment. These include the current and expected state of the economy, possible impacts on image and reputation, levels of risk, the impact on employees, product quality and service, responsibilities to society and other external stakeholders.

Changes in Interest Rates

It would be rare for a company to make a substantial investment without incurring some debt. Interest is the cost of borrowing funds. Changes in interest rates affect the amount a company will be prepared to invest. A rise in interest rates increases the cost of borrowing, so projects financed this way lose some of their attractiveness and profit is reduced.

A rise in interest rates is also likely to reduce total spending in the economy. This might affect the profitability of an investment project.

For example, a business may forecast that investment in new machinery would be profitable if 30,000 production units were sold. If sales were projected to be only 20,000 units due to a downturn in demand, investing in the machinery could be unprofitable and would not go ahead.

The impact of fluctuating interest rates is felt when borrowing is at a variable interest rate. For example, a mortgage on buildings may be taken out at a variable rate of 6% per annum. When the bank increases or decreases the interest rate, the business’s interest expense will increase or decrease accordingly. Loans and mortgages may be taken out with fixed rates which guarantee the interest rate for the period of the agreed term.  If banks increase interest rates on savings, shelving an investment project in favour of saving funds in the bank becomes an attractive option.

Strategic reactions to interest rate changes

1. If interest rate changes are relatively small, there is little need for a business to change its strategy as a movement of 1 or 2 per cent is unlikely to have much impact.

2. Companies with high levels of debt are 'highly geared', and are at risk of facing financial difficulties if interest rates rise.

3. Significant falls in interest rates should stimulate investment by businesses. With the cost of borrowing much cheaper, investment projects that in the past may have been unprofitable now become profitable.

4. If rises in interest rates are large enough to cause a sharp downtown in the economy, businesses will need to change their strategy if they are in industries most affected by the downturn. A supermarket chain is unlikely to see a marked decrease in sales, whereas an appliance store could see a large drop in sales.

Consequences of Poor Investment Decisions

O Cashflow/liquidity problems, including insolvency

O Reduced profitabilityO Loss of shareholder confidence, devaluation

of companyO Under-utilisation of new resourceO Reduced efficiency/productivityO Loss of competitive advantagesO Negative publicity, damage to brandO Lack of consumer/employee trust and loyalty