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 B U S S 3 . 6 M a k i n g I n v e s t m e n t D e c i s i o n s
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F INANCIAL S TRATEGIES AND ACCOUNTS M AKING I NVESTMENT D ECISIONS “The secret is not counting beans its growing more beans.” Roberto Goizueta “Sometimes.
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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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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?
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.