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Title: A2 Level AQA Business Studies
Description: Chapter 6 - Making Investment Decisions
Description: Chapter 6 - Making Investment Decisions
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Chapter 6: Making Investment Decisions
Reasons why businesses invest
- Investment or capital investment describes the process of purchasing fixed assets
...
- Capital investment is undertaken for 2 main reasons:
- to replace or renew any assets that have worn out (depreciated) or become obsolescent
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How investment can assist businesses to reach functional objectives
FUNCTIONAL
OBJECTIVES
EXAMPLE OF INVESTMENT DECISION ASSISTING THIS
OBJECTIVE
...
Investment appraisal used to ascertain the most cost-effective way of
reducing costs without leading to a loss of sales revenue
...
Investment appraisal in order to discover the ‘least-cost’ site for production
of a particular product
...
Investment appraisals
- Major business projects involve decisions that incorporate more than just capital equipment
...
- It is a quantitative tool in decision-making process
...
- The three investment appraisal techniques examined base their recommendations solely on the
following financial information:
- initial cost of the investment
- net return (revenue minus costs) per annum
- lifetime of the investment
Methods of investment appraisal
- 3 main methods of investment appraisal:
- payback period
- average rate of return/ annual rate of return/ average annual rate of return (AAR)
- net present value (NPV)
- Each method provides a numerical calculation of the financial benefits of an investment
...
- The exact time at which this occurs is the payback period
- It is often measured in years, but for some investments, months or weeks may be more
appropriate
...
Average rate of return
- Firms want to achieve as high a percentage return as possible
...
ARR % = total net return or surplus from a project or number of years/initial cost x 100
...
- In effect, future sums are discounted by a certain % to reflect their lower value
...
- The opportunity cost is assumed to be the rate of return that the firm could have made just by
saving the money involved
...
They ignore the time value of money
...
- There is no single agreed percentage by which future values should be discounted, as companies
face different circumstances
...
- This acts as a guide to the loss or discount that should be applied to money in the future
...
- As time progresses, the ‘present’ value of a given future sum declines
...
Exact values can be determined from a
‘present value’ table
...
- The concept of payback is easy to understand – it is how long it takes to get the money back
...
- It is a particularly relevant approach for those with some cash-flow difficulties
...
Disadvantages
- Ignores any revenue or costs that occur after the point at which payback is reached
...
- Very difficult to establish a target payback time
...
Does
not consider time value of money in the way that NPV does
...
A firm using the
payback method would fail to look at the long-term consequences of an investment
...
- The ARR shows the true profitability of the investment
...
- Percentage returns, such as the average rate of return, are usually understood by non-accountants
...
- It considers all income and expenditure as equal in value
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Net present value
Advantages
- NPV is the only method that considers the time value of money
...
- Reduces the importance of long-term estimates and helps make conclusions more accurate
...
Positive NPV means that on financial grounds, investment
should be undertaken and negative, the opposite
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- More difficult to understand than the other approaches
...
- Calculation based on arbitrary choice of percentage discount rate
...
Assessing the risks and uncertainty of investment decisions
- Firms usually take the following actions to allow for risks and uncertainties in their investment
appraisals
...
- Calculate alternative results
- Set more demanding targets, such as a short payback period or high ARR
- The other uncertainty that may occur is the market
...
- Even in stable markets, it is difficult to foresee the future
...
Evaluating quantitative and qualitative influence over investment decisions
- IA is generally a worthwhile process
...
- A careful evaluation can help an organisation avoid expensive mistakes or alert it to projects
with potential
Title: A2 Level AQA Business Studies
Description: Chapter 6 - Making Investment Decisions
Description: Chapter 6 - Making Investment Decisions