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 payback Disadvantages of payback
•Easy to calculate •Can encourage short-term thinking
rather than long term planning
•Easy to understand
•Does not consider profitability of the
•Considers the timings of cash flows investment

•Is useful for firms operating in •Ignores revenues and costs that occur
markets that undergo fast change 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 AARR Disadvantages of AARR
•Measures profitability •Does not consider timings of cash flows

•Considers the whole life of the project •More difficult to calculate than
Payback
•Easy to compare returns of different
options •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 NPV Disadvantages of NPV
•Considers the time value of money •More difficult to calculate and
understand than other methods
•Takes into account both the timings
and the amounts of cash flows •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 manegments approach to it