What do you remember from selecting financial strategies….

Test what you’ve learned!

Do Now

1) Complete the missing words

Do Now

Profit centres are a section of a business for which costs and revenues and therefore profit can be identified.

2) Circle the firm/ function of a business that would be most appropriate as a profit centre

Do Now

Branch of a chain of coffee shops

3) When considering financial strategies - describe what is meant by equity share capital

Do Now

This is were companies can raise capital through the sale of shares.

4) What is the purpose of cost minimisation? Clue….allows a business to compete…..

Do Now

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.

5) When considering cost minimisation, what manufacturing approach could be adopted to reduce costs?

Do Now

Just-in-time

6) When considering financial strategies – describe what is meant by debt capital?

Do Now

Debt capital is finance obtained from banks and other financial institutions, i.e.

– borrowed!

7) Define capital expenditure

Do Now

The purchase of assets that will remain in the business in the medium to long

term, accounted for in the balance sheet.

8) When considering capital expenditure, what is meant by ‘sign off chain’?

Do Now

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.

Making Investment Decisions (Part 2)

Module 1

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.

Learning Objectives

Re-cap?

What is the purpose of investment appraisal?

The process of analysing the financial merits of a possible future investment.

Remember - a firm will want to know:

1. How long will it take to get our money back? If invest £400,000, can we expect to get that money back within the 1st year or could it take fours years?

2. How profitable will the investment be? What profit will be generated per year by the investment?

Investment Appraisal

There are three investment appraisal techniques:

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 CInitial cost £750,000 £310,000 £550,000Inflows:      Year 1 £150,000 £125,000 £130,000Year 2 £200,000 £127,000 £132,000Year 3 £260,000 £140,000 £136,000Year 4 £260,000 £140,000 £140,000Year 5 £300,000 £130,000 £145,000Maintenance Costs £7,500 p y£15,000 p y £18,000 p y

Compare your answer to Machine A and Machine B.

Which one would be the best investment and why?

Machine C

4 years and 8

months

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.

Annual average profit = Total net cash flow 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

Don’t forget the actual investment. This will be a

negative.

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%

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.

ARR – What does it mean?

Calculate the ARR for Machine B.

Based on this method, which do you think represents the better investment?

Your turn!

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

Year Net cash flow

10% Discount factor NPV

0 (£750,000) 1 (£750,000)

1 £142,500 0.91 £129,675

2 £192,500 0.83 £159,775

3 £252,500 0.75 £189,375

4 £252,500 0.68 £171,700

5 £292,500 0.62 £181,350

The discount factor will always be given in an exam.

Year 0 will always be 1 because £750,000 today is worth £750,000.

NPV – Step 2

Add up all the NPVs to calculate the net cash gain from the project expressed in today’s terms.

If project produces a + NPV, it should be accepted.

If choosing between projects, then the one with the highest + NPV should be accepted.

Year Net cash flow

10% Discount factor NPV

0 (£750,000) 1 (£750,000)

1 £142,500 0.91 £129,675

2 £192,500 0.83 £159,775

3 £252,500 0.75 £189,375

4 £252,500 0.68 £171,700

5 £292,500 0.62 £181,350

Net Present Value £81,875

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.

ARR – What does it mean?

Calculate the NPV for Machine B.

Based on this method which do you think represents the better investment?

Your turn!

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?

Quantitative Results!

What is meant by investment criteria?

A pre-determined target against which to judge an investment.

These minimum targets/ criterion levels must be reached before an assessment decision is accepted.

What would happen if an organisation didn’t follow these rules?

Investment Criteria

Some examples may include:

Payback less than half the predicted life expectancy.

ARR 3% above rate of interest.

NPV at least 25% of initial investment

RISKS The sum of money to be

invested as well as the source of that money.

The length of time the business must commit to the project.

The impact of the investment on other aspects of the business, for example day-to-day funding.

The ease or difficulty with which the investment can be reversed.

RISKS and UNCERTAINTIES

UNCERTAINTIES The stability of the market

and the associated likely accuracy of sales forecasts.

The credibility of the source of the estimated costs and revenues.

The potential competitors’ reaction to the investment.

The stability of the economic environment in which the business operates.

1 minute challenge….

Other than the quantitative aspects of investment decisions, what qualitative factors should a firm consider?

Qualitative Results!

Qualitative Factors:

Image of the firm Workers/ exploitation Ethical

considerations Impact on wider

society

Read the case study and complete the following questions….

1, 2, 3 & 4

Homework – complete question 3.

Lowfare Airways Plc

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; it may only be willing to invest only in projects with quick 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

Financial Strategy?

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.