1. This document provides examples and practice questions for students to test their understanding of selecting financial strategies and investment appraisal techniques, including payback period, average rate of return, and net present value. 2. Students are asked to calculate and compare the results of different investment options using the three techniques and to consider both quantitative and qualitative factors that influence investment decisions. 3. Key risks and uncertainties that could impact investment decisions are also discussed, such as market stability, cost and revenue forecasts, and potential competitor reactions.

1. Do Now
What do you remember from selecting financial
strategies….
Test what you’ve learned!

2. Do Now
1) Complete the missing words
Profit centres are a section of a business for
which costs and revenues and therefore profit
can be identified.

3. Do Now
2) Circle the firm/ function of a business that would
be most appropriate as a profit centre
Branch of a chain of coffee shops

4. Do Now
3) When considering financial strategies - describe
what is meant by equity share capital
This is were companies can raise capital through
the sale of shares.

5. Do Now
4) 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.

6. Do Now
5) When considering cost minimisation, what manufacturing
approach could be adopted to reduce costs?
Just-in-time

7. Do Now
6) When considering financial strategies – describe
what is meant by debt capital?
Debt capital is finance obtained from banks and
other financial institutions, i.e. – borrowed!

8. Do Now
7) Define capital expenditure
The purchase of assets that will remain in the
business in the medium to long term, accounted
for in the balance sheet.

9. Do Now
8) When considering capital expenditure, what is meant
by ‘sign off chain’?
Due to the often large amounts of money involved in
capital 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.

10. Making Investment Decisions (Part 2)
Module 1

11. Learning Objectives
By the end of the lesson you should be able to:
1. Select and use investment appraisal techniques
2. Interpret investment appraisal findings
3. Assess the risks and uncertainties of specific investment
decisions.
4. Evaluate quantitative and qualitative influences on
specific investment decisions.

12. 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?

13. Investment Appraisal
There are three investment appraisal
techniques:
Payback
Average rate of return
Net present value

14. Payback Practice
Based on the figures below, calculate the payback period
for Machine C.
Machine A Machine B Machine C Compare your
answer to
Initial cost £750,000 £310,000 £550,000 Machine A and
Inflows: Machine B.
Year 1 £150,000 £125,000 £130,000
Which one
Year 2 £200,000 £127,000 £132,000 would be the
Year 3 £260,000 £140,000 £136,000 best investment
Year 4 £260,000 £140,000 £140,000 and why?
Year 5 £300,000 £130,000 £145,000
Maintenance Costs £7,500 p y £15,000 p y £18,000 p y

15. 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.

16. 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 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

17. 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%

18. ARR – What does it mean?
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.

19. Your turn!
Calculate the ARR for
Machine B.
Based on this method,
which do you think
represents the better
investment?

20. 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.

21. 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 always
Year 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

22. 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 project
Year 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

23. 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 due
to a fall in it’s purchasing power). A failure to do this by the
previous two techniques can be seen a weakness.
Disadvantage of NVP – it doesn’t take into account the speed of
repayment of the original investment, it can be difficult to choose
the correct discount factor and non-financial managers may find it
difficult to understand.

24. Your turn!
Calculate the NPV for
Machine B.
Based on this method
which do you think
represents the better
investment?

25. Quantitative Results!
Draw a table to summarise the
results of all three techniques
for Machine A and B.
Based on these quantitative
results, which machine do you
think represents the better
investment?

26. Investment Criteria
What 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?

27. RISKS and UNCERTAINTIES
RISKS UNCERTAINTIES
The sum of money to be invested The stability of the market and
as well as the source of that the associated likely accuracy of
money. sales forecasts.
The length of time the business The credibility of the source of
must commit to the project. the estimated costs and
revenues.
The impact of the investment on
other 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 economic
the investment can be reversed. environment in which the
business operates.

28. Qualitative Results!
1 minute challenge….
Qualitative Factors:
Other than the quantitative
Image of the firm
aspects of investment
decisions, what qualitative Workers/ exploitation
factors should a firm consider? Ethical considerations
Impact on wider
society

29. Lowfare Airways Plc
Read the case study and
complete the following
questions….
1, 2, 3 & 4
Homework – complete
question 3.

30. Financial Strategy?
Easy to calculate and understand
Advantage - Payback

31. Financial Strategy?
Takes into account the time value of money
Advantage - NPV

32. Financial Strategy?
Provides no insight into profitability.
Disadvantage - Payback

33. Financial Strategy?
Takes the opportunity cost of money into account.
Advantage - ARR

34. Financial Strategy?
Ignores what happens after the payback period.
Disadvantage - Payback

35. Financial Strategy?
Complex to calculate and communicate.
Disadvantage - ARR

36. 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

37. Financial Strategy?
The meaning of the result is often misunderstood.
Disadvantage - ARR

38. Financial Strategy?
it can be difficult to choose the correct discount.
Disadvantage - NPV

39. Re-cap Learning Objectives
You should now be able to:
1. Select and use investment appraisal techniques
2. Interpret investment appraisal findings
3. Assess the risks and uncertainties of specific investment
decisions.
4. Evaluate quantitative and qualitative influences on
specific investment decisions.