Investment decision making

Capital investment Capital investments are usually long term and expensive. Examples of capital investment include: Plant and machinery Premises A whole company Expansion Computer hardware

Investment decisions Investment decisions will take into account forecasted cash flows and profits generated by the proposed projects. An investment should either: Increase revenue, or Reduce costs in the long run

Breakeven analysis Breakeven is the output at which the business makes neither a profit nor a loss because the total revenues received have covered all the costs incurred. Breakeven analysis can be used to determine how long it will take for a business venture to start to generate profit. Breakeven = Fixed costs. Selling price – Variable cost

Return on capital employed (ROCE) ROCE is a measure of the profit generated each year compared to the costs of the project. This can be compared to the interest rate that could be earned by simply keeping the money in a bank. As there is increased risk in investing in a business, the ROCE should be higher than possible interest earned. ROCE = Operating profit x 100 Capital employed

Investment appraisal Investment appraisal techniques are quantitative decision-making tools that can be used to decide between different capital investments. Investment appraisal tools include: Payback Average annual rate of return (AARR) Net present value (NPV)

Payback Payback calculates how long it will take to pay back the initial outlay for the investment. When using this technique, the project with the shortest payback period would be chosen Advantages of paybackDisadvantages of payback Easy to calculate Easy to understand Considers the timings of cash flows Is useful for firms operating in markets that undergo fast change Can encourage short-term thinking rather than long term planning Does not consider profitability of the investment Ignores revenues and costs that occur after payback has been achieved

Average annual rate of return (AARR) AARR considers the average profit made each year during the life of the project, and compares this to the initial outlay. Firms are likely to choose the project with the highest AARR Advantages of AARRDisadvantages of AARR Measures profitability Considers the whole life of the project Easy to compare returns of different options Does not consider timings of cash flows More difficult to calculate than Payback Does not consider the time value of money

Net present value (NPV) NPV takes into account that money has a time value NPV looks at future returns of a project in today’s terms Forecasted returns are discounted to find the present value. Investments should only go ahead if present value of returns is higher than the cost of the project. Advantages of NPVDisadvantages of NPV Considers the time value of money Takes into account both the timings and the amounts of cash flows More difficult to calculate and understand than other methods The choice of discount rate used is arbitrary

Qualitative considerations Qualitative factors will also influence firms’ decisions about capital investment. These include: The aims and objectives of the firm The current and expected state of the economy Possible impacts on image and reputation Environmental and ethical considerations Past experience Levels of risk and the directors’ approach to it