7b Analysing strategic options: investment appraisal

Question 1

What is investment appraisal?

Answer 1

A series of techniques designed to assist businesses in judging the desirability of investing in particular projects.

Question 2

Businesses take decisions regarding investment in what variety of circumstances?

Answer 2

• When contemplating introducing new products.
• Expansion.
• Investing in new technology.
• Investing in infrastructure.
• In other decisions- e.g. before heavily spending on promotional campaigns, developing new brands/ products/ retraining the workforce.

Question 3

What is the data provided from investment appraisal frequently an important element of?

Answer 3

The quantitative data used by managers when taking strategic decisions such as whether or not to enter a new market, takeover another company or extend significantly the use of technology within the business.

Question 4

What are the 3 most important investment appraisal techniques?

Answer 4

• Payback
• The average rate of return (ARR)
• Net present value (NPV)

Question 5

Investment appraisial techniques depend on what assumptions?

Answer 5

• All costs & revenues can be easily & accurately forecast for some years into the future.
• Key variables (e.g. interest rates) will not change.
• The business in question is seeking maximum profits.

Question 6

What are the two major considerations for managers when deciding whether or not to invest in a non-current asset or another business?

Answer 6

• The total profits earned by the investment over the forseeable future.
• How quickly the investment will recover its cost. This occurs when the earnings from the investment exceed the cost of the investment

Question 7

Forecasts about future revenues can prove to be inaccurate for what reasons?

Answer 7

• Competitors may introduce new products/ reduce prices- reducing forecast sales & revenues.
• Tastes & fashions may change resulting in unexpected slump, or rise, in demand.
• The company may move into recession or slump (or alternatively into an upswing) unexpectedly, resulting in radically different salesfigures from those forecast.
• Costs can be equally tricky to forecast. Unexpected periods of inflation, or rising import prices, might result in inaccurate forecasts or expenditures. Can lead to a significant reduction in actual profits when compared with forecasts.

Question 8

Why must each business select the correct investment appraisal technique?

Answer 8

To decide whether the returns received from an investment are sufficient to justify the initial capital expenditure.

Question 9

What are the advantages of payback?

Answer 9

• It is quick & simple to calculate- which explains its popularity with small businesses!
• Focuses on cash flows.
• Emphasises speed of returns - good for markets which change rapidly.
• Straightforward to compare competing projects.

Question 10

What are the disadvantages of payback?

Answer 10

• It ignores the levels of profits that may be generated ultimately by the investment.
• Also ignores the timing of any receipts.

Question 11

What is ARR?

Answer 11

• Is a more complex & meaningful method of investment appraisal.
• Calculates the annual percentage rate of return on each possible investment.
• This makes it easier to compare with other investment opportunities.

Question 12

How do you calculate ARR?

Answer 12

ARR= (average annual profit/assets initial cost) x100

Question 13

ARR

How do you work out average annual profit?

Answer 13

AAP = (total profit from investment/ expected lifespan of asset in years)

Question 14

Purchasing two new delivery vans for G.Layton Ltd will cost £120,000 and a net inflow of cash of £220,000 over five years is anticipated.

Work out the ARR:

Answer 14

ARR

Total profit from investment = (£220,000 - £120,000 = £100,000)

Average annual profit = (£100,000/ 5 years = £20,000)

ARR = (£20,000/ £120,000) x 100 = 16.67%

Question 15

How do you work out total profit from investment?

Answer 15

Income from investment - Cost of investment

Question 16

What is net present value (NPV) ?

Answer 16

NPV is an investment appraisal method that incorporates discounting making it a more sophisticated investment appraisal method.

Question 17

What is discounting?

Answer 17

The process of reducing the value of future income to reflect the opportunity cost of an investment.

Question 18

What is Present value?

Answer 18

The value of a future stream of income from an investment, converted into its current worth.

Question 19

What does the technique of discounted cash flow take into account?

Answer 19

Discounted cash flow takes into account ‘time value’ of money.

This is based on the principle that money at the present time is worth more than money in the future. According to this £1,000 today is worth more than £1,000 in one or two years time.

Question 20

Time value of money

According to this £1,000 today is worth more than £1,000 in one or two years time. Why is this?

Answer 20

Risk- (Having £1,000 now is certainty, receiving the same amount at some point in the futuremay not occur. The full £1,000 may not be received/ no payment at all. An investment project may fail to provide the expected returns due to a competitors actions- change in tastes/ fashions/ technological changes.)

Opportunity cost- ( The best foregone alternative. Even if no risk existed, the time value of money would exist. Money could be placed into an interest-bearing account generating a return. )

Question 21

How is the net present value calculated?

Answer 21

For each year- multiply the net clash flow by the discount factor.

The net present value of each year is then added together & the cost of the inital investment is deducted to arrive at the overall net present value.

Question 22

THE PROCESS OF DISCOUNTING

Why is the NPV important?

Answer 22

• If the NPV is negative, the investment is not worth undertaking. This is because the present value of the stream of earnings is less than the cost of the investment. A more profitable approach would be to invest the capital in an interest-bearing account to get some return.
• When an enterprise is considering a number of possible investment projects it can use the present value figure to rank them

Question 23

What are the advantages & disadvantages of payback?

Answer 23

Advantage

• Easy to calculate
• Simple to understand
• Relevant to firms with limited funds who want a quick return.

Disadvantage

• Ignores the timing of payments.
• Excludes income received after payback.
• Does not calculate profit.
• Does not create a decision for the investment.
• May encourage short term thinking.
• Takes no account of the ‘time value of money’

Question 24

What are the advantages & disadvantages of ARR?

Answer 24

Advantage

• Measures the profit achieved on projects.
• Allows easy comparison with returns on financial investments (bank accounts for example)

Disadvantages

• Ignores the timing of payments.
• Calculates average profits- they may fluctuate wildly during the project.

Question 25

What are the advantages & disadvantages of Discounted cash flow?

Answer 25

Advantage

• Makes an allowance for the opportunity cost investing.
• Takes into account cash inflows & outflows for the duration of the investment.

Disadvantage

• Choosing the discount rate is difficult- especially for long-term projects.
• A complex method to calculate & easily misunderstood.

Question 26

What factors influence investment decisions?

Answer 26

• Rate of interest.
• Level of profit.
• Alternative investments.
• Corporate image.
• Corporate aims & objectives.
• Environmental & ethical issues.
• Industrial relations.

Question 27

Why can forecasting sales be difficult?

Answer 27

• Timescales (Over longer timescale- likely that tastes & fashions may change/ new competitors/ new products entering the market.)
• New markets ( If investment = based on entering new market, business has less experience & no financial records to use as guide for forecasting sales)
• Competitors reactions ( Deciding on particular investment may bring business into competition with rivals in new ways. May provoke response from competitors. E.g. increased advertising, price cutting- which will impact sales associated with the investment project.

Question 28

What decions may managers take to manage the risk of an investment?

Answer 28

• Purchasing raw materials on forward markets. (The firm concerned negotiates a price at present time for a product to be delivered at some agreed date in the future.)
• Building in allowances for fluctuations in sales revenue & costs (building in flexability in forecasting & thinking about how wide the ranges for sales revenues & costs will be should help managers judge the degree of risk & value of investment project.)
• Ensuring the business has sufficient financial assets available (e.g. if business is trading in a volatile/ rapidly changing market it would be sensible to make certain the business has sufficient resources to deal with any adverse circumstances.

Question 29

What is sensitivity analysis?

Answer 29

A technique that uses variations in forecasts to allow for a range of outcomes to try and judge the degree of risk.

Question 30

What does sensitivity analysis allow managers to do?

Answer 30

• Allows managers to alter independent variables such as costs & sales volumes in investment appraisal techniques and to see the outcomes.
• This helps to judge the degree of risk involved in making a specific investment.

Question 31

What does sensitivity analysis assess?

Answer 31

• Assesses the degree of risk in an investment decision.
• You can consider this model in relation to an investment decision that may be risky.
• This could be a reccomendation that a business should conduct this analysis before confirming an investment decision.
• It may be feasible to recalculate some of the investment data assuming a lower level of sales volumes, prices or a higher level of costs to assess the impact on returns.
• This is probably a better approach than using ARR or payback as the calculations are less time consuming.

Question 32

How do you work out the payback?

Answer 32

• On the diagram- you will see the cost of the investment, the different years and the return from each year.
• For each year, you will subtract the return from that year from the cost of the investment.
• You will continue to do this each year until it equals 0 and you don’t have to pay for the investment further- this is your payback period.

Question 33

How do you calculate payback?

Answer 33

Number of full years + (amount of cost left/ revenue generated by next year)

Question 34

What are different factors which influence investment decisions?

Answer 34

Economy: investment may be postponed if economic conditions are deteriorating.

Competitive environment: may need to undertake capital investment to keep up with competitors.

Industrial relations: May need to consider the impact on the workforce & strength of trade unions- e.g. introduction of new technology may reduce employees.

Corporate image & objectives: Is the investment aligned with the businesses corporate objectives/ attitudes towards corporate responsibility?

Logistics: Relates to the availability of the machinery & equipment used- especially if there is a choice between choices.

Question 35

What is sensitivity analysis?

Answer 35

An analytical tool that enables the impact of a change in a variable on a given project or investment to be examined.

Question 36

What is working capital & how is it calculated?

Answer 36

Working capital = current assets- current liabilities

• Is the day-to-day finance available for running a business and is used to measure a firm’s ability to meet current obligations, such as the payment of wages, electricity and rent.
• A high level of working capital indicates significant liquidity. It is also called net current assets or net working capital.