Part D – INVESTMENT APPRAISAL

AS 91379 9 (3.1): Demonstrate understanding of how internal factors interact within a business that operates in a global context

Investment refers to the purchase of capital goods or any other use of retained profits that is likely to earn a return in the future.  

Investment is not the same as Saving money in a bank or buying shares to try to earn dividends.

Investment is the purchase of productive capacity. For example, buying equipment or a new factory to increase capacity, meaning to increase the amount that can be produced.

One of the main reasons why businesses invest is because they have to. Most firms use plant, machinery, equipment, vehicles, tools and other capital goods.

Further investment is made to help achieve the objectives of the business. Some examples are:O Marketing, if the business wants to

increase its market shareO Research and development (R&D) O New technology, to minimise costs or

improve qualityO New capacity, if the business wishes to

diversity into new products or locationsO Acquisition of other businesses in order to

expand or to buy out a rival firm

Investment Appraisal

This is the process of evaluating the profitability or desirability of an investment project. It is a means of assessing whether or not the project is worthwhile. Investment appraisal assesses the cost of the investment against the income streams it will generate.

Every investment decision has an opportunity cost. It is essential that firms evaluate investment options. The consequences of poor investment could include:O Cash flow/liquidity problems that

could in the worst scenario lead to insolvency

O Reduced profitabilityO Loss of shareholder confidence

leading to a devaluation of shares

O Under-utilisation of a new resource

O Reduced productivity/efficiency

O Loss of competitive advantage

O Damage to brand caused by negative publicity

O Lack of consumer and employee trust and loyalty

Non-financial factorsIn addition to applying an Investment Appraisal formula to assess an investment option, management should consider other issues, such as:O Corporate objectives ~ does the investment

meet corporate objectives of the business? A long-term profit goal may allow investments with long payback periods, but if the business is facing a cash flow crisis they may prefer shorter payback period

O Capacity for risk taking ~ is the benefit worth the risk?

O Operations ~ current production capacity? Will quality standard be maintained? Links and relationships with suppliers?

O State of the economy ~ the current and forecast state of the economy will have a significant effect on investment decisions

O The extent to which future cash flows can be measured accurately

O The need to factor in the effects of inflation

Methods of Investment Appraisal

Payback periodAverage/accounting rate of returnNet present value

Payback Period

Average Rate of ReturnFactors in assessing ARR percentage valueO The ARR on other projects (the opportunity

costs)O The minimum expected return set by the

businessO The annual interest rates on loans. ARR needs

to be greater than the interest costs on borrowing. Even if the firm doesn’t need to borrow for the investment, there’s always an opportunity cost of interest foregone by keeping the money in the bank.

Net Present Value

The present value of a future sum of money depends on two factors:O The higher the interest

rate, the less value future cash in today’s money

O The longer into the future cash is received, the less value it has today.