One of the most important long term decisions for any business relates to investment. Investment is the purchase or creation of assets with the objective of making gains in the future.Typically investment involves using financial resources to purchase a machine/ building or other asset, which will then yield returns to an organisation over a period of time.
Key considerations in making investment decisions are:
1. What is the scale of the investment - can the company afford it?
2. How long will it be before the investment starts to yield returns? 3
. How long will it take to pay back the investment?
4. What are the expected profits from the investment?
5. Could the money that is being ploughed into the investment yield higher returns elsewhere?
Hazlewood Sandwiches invested £25m in a new purpose built plant at Manton Woods. In weighing up the investment they had to consider the questions outlined above. One of the approaches they used was the payback period. The payback period is the amount of time required for a project to repay its initial cost. The calculation is based on cash flows and not on profits. An investment project costs £24m.
The projected cash flows back into the business are:
Year 1 - Net cash inflow £6m
Year 2 - Net cash inflow £6m
Year 3 - Net cash inflow £6m
Year 4 - Net cash inflow £6m
You can see from the illustration above that the cumulative net cash inflow will pay back the investment at the end of the fourth year. Projects with the shortest payback periods are preferred as longer payback periods increase the risk of unforeseen circumstances arising. However, the problem of payback is that it gives no indication of the profitability of the project. An alternative method that can be employed therefore to weigh up the investment is the Accounting rate of return method.
This is calculated in the following way:
Where there are several projects under consideration, the project with the highest rate of return is the preferred project. The main problem with the techniques described so far is that they fail to account fully for the timing of cash flows. Instinctively we all know that £1 in the hand today is worth more than a promised £1 for receipts on some future date. Other investment appraisal techniques take this factor into account and are covered in the section on investment appraisal in the A2 notes.