Concept: Investment Decisions

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  • Created by: Annagc
  • Created on: 21-03-24 10:29
What is an investment decision?
'The decision made by the sponsor and governance board that justified the investment in a project, programme or portfolio. Investment decisions rely on robust investment appraisal.'
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Why must an organisation carry out a careful examination of its investments? - Cash (capital)
Cash (capital) is a scarce resource, cash flow is a key factor in the success of any organisation
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Why must an organisation carry out a careful examination of its investments? - Rate of return
The rate of return for a project must be higher than the return that could be gained by using the money elsewhere
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Why must an organisation carry out a careful examination of its investments? - Limited no. of projects
There is usually a limited number of projects that your organisation can afford, it needs to assess the viability of proposed projects and choose between them
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Why must an organisation carry out a careful examination of its investments? - Business benefits
The benefits provide a direct link between project outputs and the business strategic goals and operational needs
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Factors in an investment decision: Affordability
Are there enough funds available for investment for us to deliver the benefits?
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Factors in an investment decision : ROI
How much do we make from doing this? It's important to look at both capital and operational costs over the economic life of the project
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Factors in an investment decision: Portfolio effect
How well does this investment fit with other investments in operational and change activities
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Factors in an investment decision: Risk
Organisations are subject to operational and business risk; how can this project help reduce overall risk levels?
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Factors in an investment decision: Practicality
Is the project something that is within our organisation's technical capability
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Factors in an investment decision: Maturity of definition
Is there enough definition of the scope and requirements for us to be confident in the estimates costs and benefits
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Factors in an investment decision: Decision benefits
Are there psychological biases or blind spots influencing estimates and our ultimate decision? Is this a 'pet project'?
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Testing financial viability: Payback period
Payback is the amount of time it takes for your project to recover from the initial investment from the subsequent net cash flows
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Testing financial viability: Accounting Rate of Return (ARR)
ARR calculates the average proceeds per year over the life of the project and expresses this average as a percentage return per year on the project investment. The organisation will dictate whether ARR is calculated using gross or net returns.
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What is the future value of investment?
It is a way of working out how much a certain amount of money will be worth in the future
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What is the first step of working out the future value of investment?
Apply discounted cash flow to the value of the investment in a specific year
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What is discounted cash flow?
It estimates the future value of cash by applying a discount rate to calculate the 'present value' i.e. the cash equivalent now of a sum of money at a future date. The present value will decrease as the future period increases. The discount rate is a perc
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Testing financial viability: What is the second step of working out the future value of investment?
Calculate the Net Present Value (NPV) by adding up the values across all the years and then deduct the amount you invest. If the NPV is positive then you are returning a profit, if it is negative you are making a loss. The non-discounted returns might mak
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Testing financial viability: Internal Rate of Return (IRR)
The IRR works out the discount rate at which the NPV is 0 - this means the future cash flow is equal to the initial investment, so it gives an indication of how safe the investment is
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What does the IRR test?
How likely your project's cost and return are to change.
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What problem does calculating the IRR potentially address?
The discount rate that your organisation uses for the NPV could be wrong - a worse problem if it is too high/optimistic
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What does the higher the IRR mean?
The higher the profitability of your project
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Testing financial viability: Weighted Average Cost of Capital (WACC)
The WACC looks at equity and debt, it considers your organisation's cost to borrow money and determines if it is profitable to finance a new project. The higher the WACC, the more difficult to make a project as it tells us the cost of borrowing is too hig
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Strength of payback as a project investment decision technique
It limits the risk to the organisation
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Weakness of payback as a project investment decision technique
Short-term as it ignored returns after the payback period
Ignores the time-value of money
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Strength of benefit-cost ratio approached (ROI, ARR) as a project investment decision technique?
Allows comparison of differently sized projects
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Weakness of benefit-cost ratio approached (ROI, ARR) as a project investment decision technique?
Does not account for the timing of the returns.
Ignores the time-value of money
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Strength of Net Present Value as a project investment decision technique?
Considers the time-value of money, accounting for the impact of interest rates, inflation etc.
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Weakness of Net Present Value as a project investment decision technique?
Very sensitive to the discount rate chosen for the project
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Strength of Internal rate of return as a project investment decision technique?
Very good for looking at the sensitivity of an investment and the impact of fluctuations in economic factors
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Weakness of Internal rate of return as a project investment decision technique?
Can yield multiple values if cash flows during project are uneven (i.e. positive and negative)
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Other cards in this set

Card 2

Front

Why must an organisation carry out a careful examination of its investments? - Cash (capital)

Back

Cash (capital) is a scarce resource, cash flow is a key factor in the success of any organisation

Card 3

Front

Why must an organisation carry out a careful examination of its investments? - Rate of return

Back

Preview of the front of card 3

Card 4

Front

Why must an organisation carry out a careful examination of its investments? - Limited no. of projects

Back

Preview of the front of card 4

Card 5

Front

Why must an organisation carry out a careful examination of its investments? - Business benefits

Back

Preview of the front of card 5
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