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Making investment decisions

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  • 1. 3.6 Making investment decisions
  • 2. understand different forms of investment understand why businesses invest Learning objectives assess investment projects using appropriate methods of appraisal
  • 3. What is investment? Definitions Definitions 1. The purchase of capital 1. The purchase of capital goods goods 2. Expenditure by a business 2. Expenditure by a business which is likely to yield a which is likely to yield a return in the future return in the future
  • 4. Capital goods tools, vehicles, computers, information technology, machines Construction Spending on new buildings bought or constructed Types of investment Public sector investment About 25% of all investment, includes building of schools, roads, hospitals Stocks these include finished goods and work in progress
  • 5. To replace To replace work out / work out / obsolete obsolete equipment equipment For research For research and investment and investment Reasons for investment To grow the To grow the business business this can be organic this can be organic growth or acquisitions growth or acquisitions To minimise To minimise costs or costs or improve quality improve quality
  • 6. Factors affecting investment MOTIVES INVESTMENT DECISION EXTERNAL FACTORS ? BUSINESS CONFIDENCE RETURN COST REVENUE
  • 7. Investment appraisal Definition Definition How a private sector business How a private sector business might objectively evaluate an might objectively evaluate an investment project to decide: investment project to decide: -whether or not it is profitable -whether or not it is profitable -make comparisons between -make comparisons between different investment projects different investment projects
  • 8. The basis of investment appraisal  Compare the capital cost to the net cash flow  Capital cost  amount spent on the investment project  Net cash flow  estimated revenue generated from the project minus  estimated running costs of the project
  • 9. Payback period Payback period the amount of time the amount of time it takes for the it takes for the project to payback project to payback initial outlay initial outlay Average rate Average rate of return of return measures the met measures the met return each year as aa return each year as percentage of capital percentage of capital cost cost Methods of appraisal Net present value Net present value what the cash flow or profit earned in what the cash flow or profit earned in the future is worth in today’s money the future is worth in today’s money
  • 10. Estimate net Estimate net cash flow cash flow Calculate Calculate cumulative net cumulative net cash flow cash flow cash flow in each year cash flow in each year adjusted for cost of the adjusted for cost of the project project Payback period – method 1 Calculate payback period Calculate payback period found when cumulative net cash flow is found when cumulative net cash flow is zero zero
  • 11. Task 1  Calculate the cumulative net cash flow and the payback period from the information given on the worksheet
  • 12. Find year Find year before project before project pays back pays back Calculate ‘amount Calculate ‘amount required’ to required’ to payback payback equals cumulative cash equals cumulative cash flow for that year ==cost flow for that year cost of project ––sum of net of project sum of net cash flows cash flows Payback period – method 2 Add remaining months to Add remaining months to year year remaining months = amount required / remaining months = amount required / net cash flow in year of payback x 12 net cash flow in year of payback x 12
  • 13. Payback - alternative  An alternative ‘formula’ for calculating payback is  Years = last year in which cumulative cash flow is negative  Months = Last negative cumulative cash flow × 12 Net cash flow in year after
  • 14. Task 2  Calculate cumulative cash flow, total net cash flow and the payback period for each of the investment projects on the worksheet  Which investment project would the business choose using the payback period method of appraisal?  Can you spot a problem with the payback method of appraisal?
  • 15. Average rate of return (ARR) Calculate profit Calculate profit from project from project ==total net cash flow –– total net cash flow capital cost capital cost Calculate profit Calculate profit per annum per annum ==profit //number of years profit number of years project runs for project runs for Calculate ARR Calculate ARR net return (profit) per annum ARR = x 100 Capital outlay (cost)
  • 16. Task 3  Calculate the ARR for the three investment projects on the worksheet.  Which investment project should the business choose?
  • 17. Advantages and disadvantages Advantages Advantages allows projects to be compared allows projects to be compared clearly shows profitability clearly shows profitability can be compared to other uses of funds eg bank can be compared to other uses of funds eg bank deposits deposits easy to identify opportunity cost easy to identify opportunity cost Disadvantages Disadvantages does not take into account payback period –– does not take into account payback period important where cash flow is an issue important where cash flow is an issue does not take account of effect of time on money does not take account of effect of time on money eg money received in the future is worth less eg money received in the future is worth less than money received today than money received today
  • 18. Net present value (NPV)  The underlying principle of the NPV technique is that money received in the future is worth less that money received today  To understand this idea you should calculate the compound value of £100 invested over 5 years at a rate of interest of 10%  what is £100 worth in 5 years time?  what is £133 in three year’s time worth today?
  • 19. Net present value (NPV) Calculate present Calculate present values of annual values of annual net cash flows net cash flows ==discounted net cash discounted net cash flows flows Sum the Sum the present values present values (discounted net (discounted net cash flows) cash flows) Calculate NPV Calculate NPV ==total present values ––initial cost of investment total present values initial cost of investment
  • 20. Advantages and disadvantages Advantages Advantages takes account of the value of future earnings takes account of the value of future earnings discount rate can be changed to assess different discount rate can be changed to assess different risks or changes in financial market conditions risks or changes in financial market conditions useful where investments do not generate cash useful where investments do not generate cash flows until some time in the future flows until some time in the future Disadvantages Disadvantages the most complex method of investment appraisal the most complex method of investment appraisal unlikely to be used by small businesses unlikely to be used by small businesses result is highly dependent on discount rate chosen result is highly dependent on discount rate chosen the higher the discount rate, the fewer projects the higher the discount rate, the fewer projects are likely to be profitable are likely to be profitable