This document discusses key concepts for making investment decisions, including investment appraisal techniques like payback period, average rate of return, and net present value. It explains how to calculate and interpret each technique, along with their advantages and disadvantages. The document also covers investment criteria, risks and uncertainties, and qualitative influences that should be considered alongside quantitative factors when evaluating investments.

1. Making Investment Decisions
Unit 3

2. You will learn to:
• Understand how investment can help a business
meet its functional objectives
• Select and use investment appraisal techniques
• Interpret investment appraisal findings
• Identify and apply appropriate investment criteria
• Assess the risks
• Evaluate quantitative and qualitative influences

3. Key terms
Investment appraisal: the process of analysing the financial
merits of a possible future investment
Payback: calculation of how long it will take to recoup the cost of
an initial investment
Average Rate of Return: average annual profit expressed as a
percentage of initial investment
Net Present Value: the total net return of an investment stated in
today’s monetary value

4. Key terms
Discount factor: the rate by which future outflows are reduced to
reflect current interest rates
Time value of money: recognition of the fact that £1 today is worth
more than £1 in the future
Investment criteria: a pre-determined target against which to judge an
investment

5. The importance of investment
Investments involve spending substantial sums
of money, all investments have both financial
and opportunity costs
It is through investment that a business will
strive to achieve its objectives e.g. an objective
of growth may involve the business investing in
new machinery

6. Investment appraisal
The qualitative results of these techniques
should be considered alongside quantitative
factors.
Three investment appraisal techniques:
• Payback
• Average rate of return
• Net present value

7. Payback
This is done by first calculating the year in which the cost will be
paid back and then calculating the month in which it will be paid
back.
Lets do an example!

8. Payback example
Step 1: add up the net cash flows for ‘X’ until you
have enough to cover the initial investment
Step 2: Calculate the amount still needed for ‘X’ in
the year of payback and divide by the net cash flow
for that year and multiply by 12 to calculate the
month of payback
The shorter the payback period the less risk
involved, also the quicker the business can start to
generate profit from its investment

9. Importance of payback
Most commonly used form of investment appraisal because of
its simplicity.
Important to businesses with potential cash-flow problems
Also if the investment is to be funded by external sources of
finance

10. Disadvantages of this method
It fail to take into account any inflows after payback and in effect
ignores the overall profitability of the project
Also assumes that in the year of payback the inflow of cash is
steady across the year, this may be untrue for most firms

11. Average rate of return (ARR)
This assess the worth of an investment by
calculating the average annual profit as a
percentage of the initial investment
Lets do an example!

12. Step 1: Calculate the annual profit by adding up all
the net cash flows divided by the number of years
Step 2: Calculate the average rate of return for ‘X’
by dividing the annual profit by the initial
investment and express as a percentage
The higher the ARR, the more potentially
profitable the investment

13. The importance of ARR
The higher the ARR, the more potentially profitable the
investment
It allows easy comparison with alternative investments
It can also be compared with the current or target
ROCE

14. Disadvantages of this method
It does not take into account the timings of the cash
inflows
An investment may appear very profitable but if it takes
four years before a positive net cash flow is achieved,
this might pose too great a risk in the short-term

15. Net Present Value (NPV)
This method takes into account the total return from an
investment in today’s terms. It recognises that £100 received
today is worth more than £100 received in the future
If the £100 was invested in a bank, it would grow in value each
year, this is done by the use of a discount factor
Lets do an example!

16. Step one: Multiply each year’s net cash-flow by
the relevant discount factor, to calculate NPV
Step two: Add up all the NPVs to calculate the
net gain from the project expressed in today’s
terms
If the project is predicted to produce a positive
NPV then it should be accepted

17. Importance of NPV
Can be used to compare investments
‘Positive accept, negative reject’
It takes into account the time value of money

18. Disadvantages of this method
• It doesn’t take into account the speed of
repayment of the original investment
• It can be difficult to choose the correct discount
factor
• Non-financial managers may find the concept
hard to understand

19. Investment Criteria
These are the minimum targets, known as ‘criterion
levels’, that a possible investment must be able to
reach before it is accepted
This gives a clear rule on what is or is not acceptable
investment and prevents bias in decision making.
Example: payback less than half the predicted life
expectancy of the project

20. Risks and uncertainties
Degree of risk will be dependant on a number of
factors:
• Sum of money to be invested as well as its source
• Length of time the business wishes to commit
• Impact of the investment on other aspects of the
business
• Ease or difficulty the investment can be reversed
• Impact of the decision on other strategic choices

21. Risks and uncertainties
Degree of uncertainty will be dependant on a
number of factors:
• Stability of the market
• Credibility of the source of estimated costs and
revenues
• Stability of economic environment
• Potential competitors reactions
• Overall time period of future projects

22. Qualitative influences on investment
decisions
Includes:
• Impact on the firms image
• Impact on workers
• Ethical considerations
• Consumer perceptions
• Impact on the wider society