Capital Investing Decisions

Capital investing

Long term decisions that involves the commitment of large sums of money and usually entails the acquisition of non-current assets.

considers:

• Will the project/ asset be profitable

• Will our business earn a high rate of return on the investment?

Characteristics of CID

• Large sums of money

• Long term affect on business operations

• Decisions can't be reversed easily

• High risk decisions

Have to consider

• Cash flows and profit - will they have the money to meet debts

• Time value of money - money doesn't have the same value as it will in the future - inflation and interest rates

• Higher risk - higher return rate. High risk - high cost

Consumer preferences

They are always changing

Businesses must continue to analyse price, product, place and promotion - to be profitable

• Changing fashion

• Habits

• Social values

Competition

Must get ahead of competitors/ keep up with.

• Marketing approach

• Productivity

• Technology

• Financial investments

Must look to innovate - lower costs, maximise earnings

Government regulations

Keep in line with laws and regulations

Must abide local government regulations

• Business zoning

• Building construction

• Health and safety

Capital Expenditure Budget

• Management accounting (not published/ official)

• Financing plans

• Forecast large asset acquisitions

Investing is important

• Need to grow

• Improve productivity

• Improve product and service quality

• Keep up with trends and new tech

• Meet environmental and social expectations

Qualitative factors impacting investment decisions

• Will the business gain an advantage in the market from the investment

• Improvement of product quality

• Business image/ competitiveness

• Reduce environmental impacts

• Employee morale

Payback period method

Number of years it takes to get a return on an investment.

you accept the project that you can pay off during the shortest time, given that it is within the payback period.

Payback period pros

• Easy to calculate and understand

• Doesn't consider discount rates (makes it hard)

• Good risk indicator

• Considers liquidity (as it uses the inflows/ outflows)

Payback period cons

• Doesn't take into account time value

• Less accurate than NPV

• Doesn't directly measure target return/ yield is reached

• Cash received after payback period isn't considered - investments can take more time to mature.

Time value of money

• Money received now is more important than future (can use money to invest present time)

• Money looses value over time - inflation

• Different cash flows received at different times - make an investment more attractive than another.

Net present value method

best method to use

takes into the time value of money

NPV decisions

if 0 or positive - project will add value to business, accept

if negative - project won’t add value, reject

Advantages of NPV

• takes into account time value of money

• directly measures investment yield

• easy to make decisions from

• more accurate than payback - considers cash flow, not PROFIT

  • considers all cash flows over life of the projectDis

Disadvantages of NPV

• complex calculation

• harder to understand

• some rates need to be calculated - could be problematic

• detailed and long term forecasting required