Making Investment Decisions (introduction)
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The document outlines investment decision-making, contrasting capital and revenue expenditures, and detailing investment appraisal methods such as payback period, net present value (NPV), and average rate of return (ARR). It provides an example of a project requiring a £500,000 investment, analyzing the expected cash flows and profitability over five years, along with the benefits and drawbacks of each appraisal method. Additionally, it discusses the importance of risk assessment and qualitative factors in setting investment criteria.
Making Investment Decisions (introduction)
- 2. Capital v Revenue Expenditure Capital Capital Revenue Revenue Cash spent on Cash spent on day-to- investment in the day operations: e.g. business: e.g. Raw materials Plant & machinery Energy costs Factory buildings Wages and salaries IT systems Marketing costs Distribution equipment Office administration Fixtures and fittings
- 3. Capital expenditure = long-term The main distinction is that capital The main distinction is that capital expenditure is on non-current expenditure is on non-current assets which have an “economic assets which have an “economic life” in the business – they are life” in the business – they are intended to be kept, rather than intended to be kept, rather than sold or turned into products sold or turned into products
- 4. Many reasons for capital expenditure • To add extra production capacity • To replace worn-out, broken or obsolete machinery and equipment • To support the introduction of new products and production processes • To implement improved IT systems • To comply with changing legislation & regulations
- 5. The implication of scarce finance The Problem The Problem Choices have to be made Finance in Finance in Which investments nearly every nearly every justify the risks? business is business is How to choose between competing scarce scarce investments?
- 6. What is investment appraisal? The process of analysing whether investment projects are worthwhile
- 7. Three main methods Payback period Net present value Average rate of return
- 8. An example investment project An investment of £500,000 is expected to generate the following An investment of £500,000 is expected to generate the following revenues, costs and cash flows over the 5 year life of the project revenues, costs and cash flows over the 5 year life of the project Year Investment Revenue Costs Profit Cumulative Cash flow Cumulative Profit Cash Flow £’000 £’000 £’000 £’000 £’000 £’000 £’000 0 -500 0 0 -0 0 -500 -500 1 0 150 200 -50 -50 -50 -550 2 0 300 200 100 50 100 -450 3 0 400 150 250 300 250 -200 4 0 600 150 450 750 450 250 5 0 700 100 600 1,350 600 850 Total 500 2,150 800 1,350 850
- 9. Payback period The payback period is the time it takes for a project to repay its initial investment
- 10. Where does payback occur? Payback for the project arises Payback for the project arises £200,000/£450,000 through Year 4 £200,000/£450,000 through Year 4 = approx 23 weeks through Year 4 = approx 23 weeks through Year 4 So the payback period = 3 years + 23 weeks So the payback period = 3 years + 23 weeks
- 11. Benefits and drawbacks of payback Advantages Disadvantages Simple and easy to calculate + easy Ignores cash flows which arise after the to understand the results payback has been reached – i.e. does not look at the overall project return Focuses on cash – which is Takes no account of the “time value of normally scarce money” Emphasises speed of return; good May encourage short-term thinking for markets which change rapidly Straightforward to compare Ignores qualitative aspects of a decision competing projects Does not actually create a decision for the investment
- 12. Net present value Net present value Net present value (“NPV”) calculates the (“NPV”) calculates the monetary value now of monetary value now of the project’s future cash the future cash flows flows
- 13. The importance of time ? Would you rather have? Would you rather have? £100 or £100 Now Now In 12 months In 12 months
- 14. The time value of money • Better to receive cash now rather than in the future • Future cash flows are “worth less” • Use discount factors to bring cash flows back to their “present value” • Relevant discount factor determined by required rate of return
- 15. NPV of the project NPV of the project is positive (£405k), NPV of the project is positive (£405k), suggesting the investment is worthwhile suggesting the investment is worthwhile using a 10% discount rate using a 10% discount rate
- 16. Benefits and drawbacks of NPV Advantages Disadvantages Takes account of time value of More complicated method – users money, placing emphasis on earlier may find it hard to understand cash flows Looks at all the cash flows involved Difficult to select the most through the life of the project appropriate discount rate – may lead to good projects being rejected Use of discounting reduces the The NPV calculation is very impact of long-term, less likely cash sensitive to the initial investment flows cost Has a decision-making mechanism – reject projects with negative NPV
- 17. Average rate of return (“ARR”) The average rate of return The average rate of return (“ARR”) method looks at (“ARR”) method looks at the total accounting return the total accounting return for a project to see if it for a project to see if it meets the target return meets the target return
- 18. Calculating ARR Total net profit / No years ARR (%) = x 100 Initial cost Example Project Example Project Total net profit (5 years) = £1,350,000 Total net profit (5 years) = £1,350,000 Divided by project life = £1,350,000 //5 Divided by project life = £1,350,000 5 = £270,000 = £270,000 Divided by the initial cost (£500,000) = £270,000 // Divided by the initial cost (£500,000) = £270,000 £500,000 = 54% £500,000 = 54%
- 19. Benefits and drawbacks of ARR Advantages Disadvantages ARR provides a percentage Does not take into account return which can be cash flows – only profits (they compared with a target return may not be the same thing) ARR looks at the whole Takes no account of the time profitability of the project value of money Focuses on profitability – a Treats profits arising late in key issue for shareholders the project in the same way as those which might arise early
- 20. Risks and uncertainties in investment appraisal Risk Issue Length of the The longer the project, the greater the risk that estimated revenues, project costs and cash flows prove unrealistic Source of the Are estimated project profits and cash flows based on detailed data research, gut feel, or a little of both? Size of the An investment that uses most of the available business funds is, by investment definition, more risky than a smaller project. Risk is also about the consequences to the business if something goes wrong! Economic and A major issue for most large investments. Most projects will make market assumptions about demand, costs, pricing etc which can become environment wildly inaccurate through changing market and economic conditions Experiencec of A project in a market in which the management team has strong management experience is a lower-risk proposition than one in which the business team is taking a step into the unknown!
- 21. Qualitative factors to consider • The impact on employees • Product quality and customer service • Consistency of the investment decision with corporate objectives • The business’ brand and image, including reputation • Implications for operations, including any disruption or change to the existing set-up • Responsibilities to society and other external stakeholders
- 22. Setting the investment criteria • Payback, NPV and ARR can create conflicting results – how to decide? • Possible criteria might suggest only accepting investment proposals which meet at least two measures • E.g. – A payback within four years – ARR of at least 20%, with no profits taken into account beyond Year 5 – NPV of at least 25% of the initial investment
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