FINANCIAL STRATEGIES AND ACCOUNTS

MAKING INVESTMENT DECISIONS

“The secret is not counting beans its growing more beans.”

Roberto Goizueta

“Sometimes your best

investments are the ones

you don’t make.”

Donald Trump

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MAKING INVESTMENT DECISIONS

IN THIS TOPIC YOU WILL LEARN ABOUT:

Conducting investment appraisal: selection of appropriate methods, calculation and interpretation of findings

Investment criteria

Assessing the risk and uncertainties of investment decisions

Evaluating quantitative and qualitative influences on investment decisions

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You will need access to the internet to watch this clip

Making Investment Decisions

Why do businesses invest? To expand Gain market share Competitive advantage Update facilities Relocation TO MEET CORPORATE AND FUNCTIONAL

OBJECTIVES

What is an investment decision? A strategic decision relating to capital

expenditureYou will need access to the internet to watch this video clip

What investment decisions has Tesco made?What factors will influence the success or failure of

these investments?

How do businesses make investment decisions?

Analysis of the quantitative factors Investment appraisal techniques Investment criteria

Plus Analysis of the qualitative factors

Social environment Customer reaction

Focussed on Whether it will help achieve corporate and

functional objectives

Investment Appraisal

Numerical techniques that analyse the predicted financial outcomes of potential investments

Weighs up the cash outflows (initial investment plus continued costs) against the future cash inflows

Often used to make comparisons between different investment opportunities Site A or site B Machine X or machine Y Product extension or new product

Investment Appraisal –Net Cash Flow Table

There are 3 different techniques you will learn in this unit Payback Average Rate of Return Net Present Value

For all 3 the starting point is the same, draw up a Net Cash Flow Table Year 0 is the year of the initial investment Cash out flows or negative net cash flows are

shown in ( )

SCENARIOFive years ago the luxury hotel chain, Andersons, was selling 3 of its less profitable hotels.

Hans saw this as a great opportunity and purchased “The Hotel Mermaid” in his home city of Copenhagen. Since then Hans has worked to improve the quality of service provided to guests and personally analyses the customer feedback questionnaires. Facilities are normally rated as good or very good but Hans had noticed that the Spa frequently only got average. He thinks it is time to upgrade these facilities and commissions a consultant to carry out an independent report investigating whether the hotel should seek finance to fund this project.

One technique used by the consultant was Investment Appraisal.

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What ratios might they have used to identify these hotels?

What other techniques might the consultant have used?

SCENARIO – THE FIGURES

Initial Investment £13m Forecast Annual Cash inflow

Year 1 £3m Year 2 £6m Year 3 £8m Year 4 £8m

Annual Cost Year 1-3 £1m Year 4 £1.5m

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What techniques may the consultant have used to estimate these figures?

What factors will affect the likely accuracy of these figures?

FIRST – DRAW A NET CASH FLOW TABLE

Year Cash out Cash in Net cash flow

0 £13m 0 (£13m)

1 £1m £3m £2m

2 £1m £6m £5m

3 £1m £8m £7m

4 £1.5m £8m £6.5m

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NCF = cash in – cash out

Why might the annual cost be predicted to be higher in year 4?

IAT 1 : PAYBACK

Calculates how long it will take to pay back the cost of the initial investment

It shows how many years and months Step 1: Calculate during which year the

investment cost will be covered Initial cost = £13m Cumulative net cash flow

Year 1 £2mYear 2 £7mYear 3 £14m

Therefore payback is 2 years and x months

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£14m is enough to cover the initial £13m therefore payback is during year 3

IAT1 : PAYBACK

Step 2 : Calculate how many months At end of year 2 £7m had been paid back leaving

£6m to be paid in year 3 (£13m - £7m) In year 3 £8m is the net cash inflow over the full

12 months £7m/12 = £0.58m per month £6m (remaining to be paid)/£0.58m per month = 10.3 months

Payback is therefore 2 years and 11 months

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IAT1 : PAYBACK

The longer the payback period the greater the degree of risk and uncertainty

Need to also consider how the investment is being funded e.g. If via a bank loan what will impact be on gearing

Does not take into account what happens after payback

Assumes that in the year of payback that the cash inflow is equal each month.

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Why is this unlikely to be true in Hans’ scenario?

IAT2: AVERAGE RATE OF RETURN Calculates average profit as a percentage of

the cost of the initial investment

Step 1: calculate average annual profit Total net cash flow = (13m) + 2m + 5m + 7m +

6.5m = £7.5m Step 2: £7.5m / 4 years = £1.875m Step 3: calculate ARR

Divide average annual profit by initial investment x 100

£1.875m / £13m x 100 ARR = 14.4%

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IAT2: AVERAGE RATE OF RETURN

Allows for easy comparison with other forms of investment

The higher the ARR the better the proposed investment

However there is no consideration given to the timings of the inflow

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Explain why it would be useful to compare ARR to ROCE and interest rates

Why might a firm with a positive ARR still reject an investment if it primarily generates the profit only after several years?

IAT 3 : NET PRESENT VALUE

Calculates the total return on an investment taking into account the time value of money.

A discount factor of 10% provides the following discounts:

Yr 0 = 1, Yr 1 = 0.91, Yr 2 = 0.83, Yr 3 = 0.75, Yr 4 = 0.68

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Discounts the return each year to recognise that £1 today is not the

same as £1 in 3 years time

The AQA exam board will not ask you to calculate the discount factor this will be given to you.

IAT 3 : NET PRESENT VALUE

Step 1 : Multiply each net cash inflow by the relevant discount factor

Step 2 : add up all the annual NPVs to calculate the total return on the investment

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Year Net cash inflow

Discount factor

NPV

0 (£13m) 1 (£13m)

1 £2m 0.91 £1.82m

2 £5m 0.83 £4.15m

3 £7m 0.75 £5.25m

4 £6.5 0.68 £4.42m

£2.64m

IAT 3 : NET PRESENT VALUE

A positive NPV implies a worth while investment

But is it a big enough return to justify the risk?

Takes into account the time value of money but the discount factor is a prediction

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What would happen to the NPV if the discount factor went up?

Based on these three quantitative techniques advise Hans on whether or not the Spa is a worth while investment.

What other factors should be taken into consideration?

INVESTMENT CRITERIA

A predetermined set of guidelinesagainst which an investment canbe judged

Minimum targets expected from investments

Will partly depend upon culture Risk taker or risk averse

May be influenced by the level of confidence in the predicted figures

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RISK AND UNCERTAINTIES

Investment appraisal is trying to minimise risk or help inform decision making

Key considerations in assessing the degree of risk or uncertainty are: Gearing Stability Opportunity cost Predictions Competitor reactions Time frame

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QUALITATIVE FACTORS

Stakeholders and

external factors

Suppliers

Shareholders

Community

Employees

Management

Environment

Customers

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ACTIVITYB

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Christian, Hans business partner, is a keen tennis player and although he agrees that the Spa needs a facelift he thinks this could be achieved at a lower cost. He proposes that a better investment, giving the hotel a USP, would be to offer professional tennis coaching. He proposes they build 2 new courts, add flood lighting to the old and new courts, upgrade the changing rooms and hire a professional coach. His plans would also cost £13m but Christian predicts that the annual running costs would be 30% higher than those of the Spa. Hans however predicts that the annual cash inflow would be £8m from year 1.

1. Carry out all 3 IATs on Christian’s proposal2. Prepare a presentation for Hans and Christian weighing up

the pros and cons of both options.3. Make a fully justified recommendation on whether they

should go ahead with the Spa, tennis centre or neither.