Year 1 112,000Year 2 114,000Year 3 118,000Year 4 122,000 466,000Year 5 127,000 593,000550,000 – 466,000 (Year 4) = 84,00084,000127,000 (Year 5) x 12 = 7.934 years and 8 monthsMachine A (3 years and 8 months)/ Machine B (2 years 8/9 months)
3.7 making investment decisions (part 2) - moodle
Do NowWhat do you remember from selecting financial strategies…. Test what you’ve learned!
Do Now1) Complete the missing words Profit centres are a section of a business forwhich costs and revenues and therefore profit can be identified.
Do Now2) Circle the firm/ function of a business that wouldbe most appropriate as a profit centre Branch of a chain of coffee shops
Do Now3) When considering financial strategies - describewhat is meant by equity share capitalThis is were companies can raise capital through the sale of shares.
Do Now4) What is the purpose of cost minimisation?Clue….allows a business to compete….. Cost minimisation allows a business to compete on price. A business that has high market share or is a market leader will be in a position of power when it comes to negotiating terms and conditions with suppliers.
Do Now5) When considering cost minimisation, what manufacturingapproach could be adopted to reduce costs? Just-in-time
Do Now6) When considering financial strategies – describewhat is meant by debt capital?Debt capital is finance obtained from banks and other financial institutions, i.e. – borrowed!
Do Now7) Define capital expenditure The purchase of assets that will remain in thebusiness in the medium to long term, accounted for in the balance sheet.
Do Now8) When considering capital expenditure, what is meantby ‘sign off chain’? Due to the often large amounts of money involved incapital expenditure, decisions are taken vary seriously. Large organisations will have a sign off chain –permission must be sought to make the purchase from higher up the up hierarchy.
Learning ObjectivesBy the end of the lesson you should be able to:1. Select and use investment appraisal techniques2. Interpret investment appraisal findings3. Assess the risks and uncertainties of specific investment decisions.4. Evaluate quantitative and qualitative influences on specific investment decisions.
Re-cap? Remember - a firm will want to know: What is the purpose of 1. How long will it appraisal?our investment take to get money back? If invest £400,000, can we expect to get that money backThe processstof analysing it within the 1 year or could takethe financial merits of a fours years? possible future 2. How profitable will the investment investment. be? What profit will be generated per year by the investment?
Investment AppraisalThere are three investment appraisaltechniques: Payback Average rate of return Net present value
Payback Practice Based on the figures below, calculate the payback period for Machine C. Machine A Machine B Machine C Compare your answer toInitial cost £750,000 £310,000 £550,000 Machine A andInflows: Machine B.Year 1 £150,000 £125,000 £130,000 Which oneYear 2 £200,000 £127,000 £132,000 would be theYear 3 £260,000 £140,000 £136,000 best investmentYear 4 £260,000 £140,000 £140,000 and why?Year 5 £300,000 £130,000 £145,000Maintenance Costs £7,500 p y £15,000 p y £18,000 p y
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. Don’t forget the actual investment.Annual average profit = Total net cash flow This will be a negative. Number of yearsTotal net cash flow for Machine A = (y0) (£750,000) + (y1) £142,000 + (y2)£192,500 + (y3) £252,500 + (y4) £252,500 + (y5) £292,500 = £382,500Average 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 investmentAverage Rate of Return = £76,500 x 100 = 10.2% £750,000The ARR for Machine A is 10.2%
ARR – What does it mean?The higher the ARR the more potentially viable theinvestment.The advantage of ARR is that it allows for easy comparisonwith alternative forms of investment, such as interest ratesoffered at a bank or compared to ROCE.Disadvantage – it does not take into account the timings ofthe cash flow inflows. An investment may seem profitablebut it may take four years for a positive cash flow to beachieved.
Your turn!Calculate the ARR forMachine B.Based on this method,which do you thinkrepresents the betterinvestment?
Net Present Value (NPV) NPV takes into account the total return from an investment in today’s terms. It recognises that £100 received today is worth more than £100 in the future. If the £100 received today was invested in the bank, it would grow in value each year. However, if it was invested in an asset, it may lose value each year – this is calculated using the discount factor. Discount factor – the rate at which future cash flows are reduced (discounted) to reflect current interest rates.
NPV – Step 1 Multiply each year’s net inflow by the relevant discount factor, to calculate NPV. For example: £142,500 x 0.91 = £129,675 10% Discount The discount factor will alwaysYear Net cash flow factor NPV be given in an 0 (£750,000) 1 (£750,000) exam. 1 £142,500 0.91 £129,675 2 £192,500 0.83 £159,775 Year 0 will always be 1 because 3 £252,500 0.75 £189,375 £750,000 today is 4 £252,500 0.68 £171,700 worth £750,000. 5 £292,500 0.62 £181,350
NPV – Step 2 Add up all the NPVs to calculate the net cash gain from the project expressed in today’s terms. 10% Discount If projectYear Net cash flow factor NPV produces a + NPV, it should be 0 (£750,000) 1 (£750,000) accepted. 1 £142,500 0.91 £129,675 2 £192,500 0.83 £159,775 If choosing between projects, 3 £252,500 0.75 £189,375 then the one with 4 £252,500 0.68 £171,700 the highest + NPV should be 5 £292,500 0.62 £181,350 accepted.Net Present Value £81,875
ARR – What does it mean?The simple rule of ‘positive NVP accept, negative NVP reject’provides managers with an easy guide to decision-making.Advantage of NVP – Takes into account the time value of money(recognition that £1 today is worth more than £1 in the future dueto a fall in it’s purchasing power). A failure to do this by theprevious two techniques can be seen a weakness.Disadvantage of NVP – it doesn’t take into account the speed ofrepayment of the original investment, it can be difficult to choosethe correct discount factor and non-financial managers may find itdifficult to understand.
Your turn!Calculate the NPV forMachine B.Based on this methodwhich do you thinkrepresents the betterinvestment?
Quantitative Results!Draw a table to summarise theresults of all three techniquesfor Machine A and B.Based on these quantitativeresults, which machine do youthink represents the betterinvestment?
Investment CriteriaWhat is meant by investment Some examples may include:criteria? A pre-determined target against Payback less than half the which to judge an investment. predicted life expectancy. These minimum targets/ criterion levels must be reached ARR 3% above rate of before an assessment decision is interest. accepted. What would happen if an NPV at least 25% of initial organisation didn’t follow these investment rules?
RISKS and UNCERTAINTIESRISKS UNCERTAINTIESThe sum of money to be invested The stability of the market andas well as the source of that the associated likely accuracy ofmoney. sales forecasts.The length of time the business The credibility of the source ofmust commit to the project. the estimated costs and revenues.The impact of the investment onother aspects of the business, for The potential competitors’example day-to-day funding. reaction to the investment.The ease or difficulty with which The stability of the economicthe investment can be reversed. environment in which the business operates.
Qualitative Results!1 minute challenge…. Qualitative Factors:Other than the quantitative Image of the firmaspects of investmentdecisions, what qualitative Workers/ exploitationfactors should a firm consider? Ethical considerations Impact on wider society
Lowfare Airways PlcRead the case study andcomplete the followingquestions…. 1, 2, 3 & 4Homework – completequestion 3.
Financial Strategy?Easy to calculate and understand Advantage - Payback
Financial Strategy?Takes into account the time value of money Advantage - NPV
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; itmay only be willing to invest only in projects withquick payback. Advantage - Payback
Financial Strategy?The meaning of the result is often misunderstood. Disadvantage - ARR
Financial Strategy?it can be difficult to choose the correct discount. Disadvantage - NPV
Re-cap Learning ObjectivesYou should now be able to:1. Select and use investment appraisal techniques2. Interpret investment appraisal findings3. Assess the risks and uncertainties of specific investment decisions.4. Evaluate quantitative and qualitative influences on specific investment decisions.