f inancial s trategies and accounts m aking i nvestment d ecisions “the secret is not counting...
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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.