Making decisions about investing in a business can impact all aspects of a business.

As a manager, you need to have an

understanding about how these decisions are made.
Your ability to analyze opportunities for investing in the business and make a prudent decision will directly enhance
your business.
Decision making matrix
In today's dynamic environment, nothing is permanent except change. Only companies that adjust their operations
continually will survive and prosper.Making any strategic change to the way you do business usually involves spending
a lot of money. It can be expensive, if not impossible, to reverse an investment decision, and future costs and benefits
are difficult to predict.
That is why managers should analyze investment decisions very carefully. This topic teaches you what should happen
at each phase of the investment decision-making process.
The managers of a company can influence its future by the kind of investments they choose to make. There are two
primary types of investment:
Investment by a company in its own business activities.
Investment by a company in the financial securities of another.
Managers are motivated to consider and evaluate investment options for many reasons. These include the need to
replace assets, reduce costs, expand operations, or react to external variables such as changing markets or legislation.
Relace assets
Assets need to be replaced at some point
Questions are
Do you need to do it?or there
Reducing costs
Is important for all companies and ratio analysis might help that
Expansion
Aquiring companies,Fuding for the internal expansion which is known as organic expansion

The process of deciding which investment options are most financially rewarding involves three key stages.

Proposal stage
he first stage of the investment decision-making process is the proposal stage.

Most investment proposals are generated by middle managers and project managers. These people are in the best
position to identify possible improvements as they are the most in touch with how the business operates.

For example, the production manager is likely to propose an investment project to increase productivity while the
marketing manager will probably have ideas for increasing sales. It's unlikely that any manager will propose to invest
in new IT equipment or software without at least involving the IT manager. The best proposals generally come from the
specialists.

Before a manager writes a proposal, she does a lot of preliminary investigation. She is likely to give the issue some
serious thought, perform some initial calculations, and discuss her ideas with other stakeholders in the process.

Then, if she is confident that the project is feasible, she writes a short proposal presenting her initial findings and
submits it for inclusion in the capital budget.

Most companies have a capital budgeting process that requires managers to submit investment proposals well in
advance. This way, the company accountant can estimate the total capital requirements accurately and think carefully
about the best way to raise the necessary finance.
Jenny is the production manager at ComITT, a computer hardware manufacturer. She is studying data from the
marketing department, which shows that sales of the ComITT computers have grown in the past twelve months.

Jenny and her contacts in the marketing department are convinced that the growth in sales justifies the addition of
another production line.

To figure out how many computers the company needs to produce to pay for the new line, Jenny uses the simple yet
reliable CVP analysis technique. The output of her investigation will be a short proposal for inclusion in the capital
budget.
Appraisal stage
The second stage of the investment decision-making process is the appraisal stage. Typically, once you have submitted
a short proposal for inclusion in the capital budget, a more detailed evaluation will follow. This is known as project
appraisal.

Project appraisal is the process of evaluating a proposed project to forecast its long-term benefit to the company. It's
really about deciding if something is a good idea or not! The number of people who conduct a project appraisal varies
depending on the scale of the project and the size of the company.
Sometimes, the objective of the project appraisal is to select the most financially rewarding investment option from a
range of feasible alternatives.

Jenny's final proposal to increase production includes two options.

The first proposes the addition of a new production line with new plant equipment, systems, and personnel. The
alternative is the addition of a new shift - a night shift. This would involve higher wages for unsocial hours but no
equipment costs.

Jenny is going to work with Mac, ComITT's accountant, to evaluate these alternatives in detail and to select the more
financially rewarding option.
Approval stage
The third stage of the investment decision-making process is the approval stage. At the approval stage, senior
management, with the help of a financial specialist, determines the source and quantity of capital to be used to fund a
project. The manager who proposed the project may not be involved at this stage. However, the proposer may be
involved in appointing a project manager or designing metrics to monitor the progress of the project.

The decision-makers must be satisfied that the proposal meets the necessary profitability criteria and is compatible with
the overall strategy of the business.
Before approving an investment project, the approvers must ensure that:, The return from the project will exceed the
cost. The project aligns closely with the objectives of the business. The project is more financially rewarding than
others that have been rejected as being not sufficiently profitable.
If there are insufficient funds to undertake all the proposals put forward, the approvers may rank the proposals in order
of priority.
A company influences its future by the kind of investments it chooses to make. The process of deciding which
investments are most feasible and financially rewarding consists of three stages.

This process is of fundamental importance because capital investments are usually expensive, linked to the company's
strategic objectives, and difficult to reverse. They also involve a high degree of risk and uncertainty.

CVP ANALYSIS
The key question you will ask yourself when faced with a crucial management decision is ''How will this course of
action affect costs, revenues, and profits?'' You won't find the information you need to answer this question in the
historical data provided by routine accounting systems. Instead, you need to analyze the interrelationship between cost,
volume, and profit. This topic teaches you how to conduct a cost-volume-profit (CVP) analysis.
Cost-volume-profit (CVP) analysis is a useful tool for evaluating proposed investment projects. It assesses the viability
of a project by analyzing the relationship between three key variables - cost, volume, and profit.

Will the costs be so high that your project cannot be profitable unless the volume of production is very high? What
volume of products must you produce to break even? If you lower prices, how many more products will you have to
sell?

These are the kinds of questions that a CVP analysis can answer.
To understand CVP analysis, you need to understand fully which costs are fixed and which costs are variable in a
company's operations. Click each type of cost in the diagram to see some examples.
Fixed costs are just that - fixed. They are not influenced by the level of activity within the company unless the range of
activity increases beyond a certain level. For example, if an increase in production requires extra floor space, the rent,
normally a fixed cost, will rise. Variable costs are the opposite of fixed costs. They vary completely according to the
level of activity in the company.
CVP analysis can tackle a variety of questions that fall logically into your analysis of a problem, including: What is the
contribution per unit? hat is the break-even point? What profit do you need to make? What profit do you need to make?
hat is the minimum selling price?
Jenny is the production manager at ComITT - a computer hardware manufacturer. Steve, her colleague in the marketing
department, has convinced her that he can sell more computers than the company is currently producing. Jenny is using
CVP analysis to explore the possibility of increasing the company's production by as much as 30%. If the CVP analysis
is positive, Steve will send his proposal to senior management for review as part of the capital budgeting process.
The first question that Jenny needs to answer is ''What is the contribution per unit?'' She needs to find out the
contribution that each computer produced by ComITT makes to the company.

To get this figure, Jenny must first calculate the contribution margin by subtracting variable costs from revenue.
ComITT currently produces 50,000 computers a year and sells them at $800 each, making $40 million in revenue.

The variable costs of producing 50,000 computers in terms of raw materials and labor costs are $26.5 million. By
subtracting the variable costs from revenue, Jenny arrives at a contribution margin of $13.5 million.
By now, you are probably familiar with gross profit (sales revenue minus the cost of goods sold). So, you may be
wondering what is the difference between gross profit and the contribution margin.

You calculate gross profit using the cost of goods sold, but this doesn't account for all of the variable costs used in
calculating the contribution margin. The cost of goods sold is just that - the cost of the goods actually sold, in raw or
finished form. Variable costs, however, cover many more expenses, such as wages, sales commission, and delivery
charges.
Now that Jenny has calculated the contribution margin, she can go on to calculate the contribution per unit. She knows
that ComITT sells computers at $800 each so the sales revenue generated from each computer is $800.

If the variable cost of producing 50,000 computers is $26.5 million, the variable cost of producing one computer is
$530.

By subtracting the variable cost of producing each computer from the revenue per computer, Jenny arrives at a
contribution per unit of $270. This is the contribution that each computer produced by ComITT makes to the company.
Having calculated the contribution per unit, Jenny has the data she needs to figure out how many computers ComITT
needs to produce in order to cover its fixed costs, to 'break even' in other words.

To calculate ComITT's current break-even point, she divides fixed costs ($9.5 million) by the contribution per unit
($270) to arrive at a figure of 35,185.
This means that ComITT has to produce at least 35,185 computers over the relevant time period - in this case, one year
- to ensure that ComITT does not make a loss. ComITT's break-even point is 35,185.
Jenny now knows how many computers she must produce to break even, but how many must she produce to achieve
the target profit of Steve, her marketing colleague? "What profit do you need to make?" is the next question she must
consider.

Steve believes that he can raise profits from $4 million to $4.7 million if the factory increases its output by 30%. So, his
total required profit is $4.7 million ($4 million plus $0.7 million).

He wants Jenny to figure out if she can increase production in such a way that the extra costs will be viable.
After some investigation, Jenny concludes that the best way to increase production is to add another production line
inside ComITT's existing facility. This will help to keep the increase in fixed costs as low as possible.

Jenny's current fixed costs are $9.5 million. She calculates that investment in a new production line, including
equipment and furniture, will increase her current fixed costs by $1.8 million to $11.3 million.

To keep her model workable for now, Jenny assumes that there will be no change in the unit contribution of each
computer as a result of this increase.
ComITT has to produce 35,185 computers at the moment to break even. How much will it have to produce to break
even if Jenny introduces the new line and fixed costs go up by $1.8 million as she anticipates?

By dividing the new fixed costs figure ($11.3 million) by the contribution per unit, Jenny calculates that ComITT
would have to produce 41,852 computers - 6,667 more than it has to produce to break even at the moment.

However, Jenny is not introducing this new production line to simply break even. She is doing it to achieve Steve's
required profit of $4.7 million.
To find out how many computers ComITT will have to produce to achieve Steve's required profit of $4.7 million,
Jenny must add the required profit to the fixed costs and divide this figure by the contribution per unit.

To make this project viable and to increase profits by $0.7 million, ComITT would need to produce 59,260 computers
-- 9,260 more than it is currently producing.
If all goes according to plan, Steve's project to increase profits by $700,000 as a result of boosting production is
entirely viable. But not everything in life is entirely predictable. It's time to consider some 'what if' scenarios.

For example, Steve would like to know what would happen if, as he suspects, the cost of raw materials were to
increase. There are forecasts that memory chips may increase in price as demand outstrips supply worldwide.

If the cost of raw materials did go up, how many computers would ComITT need to build and sell for the project to
remain viable?
Steve estimates that if the cost of raw materials increased, it would take the variable cost of each computer from $530
to $550. This $20 dollar increase would cause the contribution of each computer to drop from $270 to $250.

ComITT would need to build 64,000 computers for the project to remain viable. Increasing the variable costs by 3.8%
drives the need to increase the computer build by 8%! This shows how important it is for ComITT to control its
variable costs.
Finally, Steve wants to know what an increase in costs would mean for the selling price of ComITT's computers.

The current selling price is $800 and he knows that the market is extremely competitive and price-sensitive at the
moment. So, what is the least that ComITT could charge per computer and still break even on the project?

To answer this question, Steve uses the same calculations as before but approaches them from a different perspective.
Earlier in the topic, Jenny divided fixed costs and the required profit by the contribution per unit to arrive at the number
of units ComITT needed to produce.

Now, Steve is dividing fixed costs and the required profit by the number of units that need to be produced to arrive at
the necessary contribution per unit.

The new fixed costs associated with the proposal are $11.3 million (the current $9.5 million and the additional $1.8
million that Jenny has estimated for the new production line). The required profit is still the same - $4.7 million. This
gives Steve a total required contribution value of $16 million. Earlier in the topic, Jenny divided fixed costs and the
required profit by the contribution per unit to arrive at the number of units ComITT needed to produce.
Now, Steve is dividing fixed costs and the required profit by the number of units that need to be produced to arrive at
the necessary contribution per unit.

The new fixed costs associated with the proposal are $11.3 million (the current $9.5 million and the additional $1.8
million that Jenny has estimated for the new production line). The required profit is still the same - $4.7 million. This
gives Steve a total required contribution value of $16 million.
Steve believes that he can sell 30% more computers than the 50,000 that ComITT is producing at present - that is,
65,000 computers.

By dividing the required contribution value by the required number of units, Steve calculates that each computer will
have to contribute $246.

To calculate the required selling price - the minimum price he can sell at - Steve adds the variable cost per computer
($550 now) to the contribution per unit ($246).

This gives him a required selling price of $796 per computer. As ComITT is currently marketing its computers at $800,
the project appears to be viable.
Steve decides to write his proposal, with support from Jenny, and submit it to senior management for review.

He includes both scenarios - the scenario with no increase in variable costs and the scenario with a $20 increase in
variable costs.

If he can convince senior management that the project is viable, the project will be included as part of the capital
budget.

What do you think Steve's profit will look like if this project goes ahead?
If Steve sells 65,000 computers at $800 each, he will generate $52 million in revenue. If variable costs increase by $20
per unit, the total variable costs will be $35,750,000. That leaves a contribution margin of $16,250,000.

If variable costs do not increase, they will total $34,450,000 and leave a contribution margin of $17,550,000.
By subtracting the fixed costs ($11.3 million) from the contribution margin, Steve calculates that the first scenario
results in $4,950,000 profit and the second scenario arrives at $6,250,000. Both results satisfy Steve's $4.7 million
target so this makes for a very attractive proposal!
You have seen how useful CVP analysis can be in the early stages of project planning. Most managers build a CVP
model on a spreadsheet so that they can quickly and easily adjust variables and compare the results of various
scenarios.

In the case of ComITT, all computers sell for $800. Most companies, however, have a range of products that sell for
different prices, generate different revenues, and offer different contributions.

Despite these variations, it is possible to calculate a contribution to sales for each product. You can then make decisions
on which products to increase in volume and which products to produce less of or even discontinue.

Project appraisal techniques

Steve is the marketing director at ComITT - a computer hardware manufacturer that makes good profits by keeping a
tight focus on costs.

Jenny is the production director.

In their combined efforts, Steve and Jenny have succeeded in having a major investment project included in ComITT's
capital budget for this year. This project involves adding a new production line to ComITT's facility.

The new line will increase ComITT's volume (V) from 50,000 to 65,000 units per year, at a cost (C) of an additional
$1,800,000 in fixed costs. Steve and Jenny also aim to take profits (P) up from $4,000,000 to at least $4,700,000 as a
result of the project.
As you may know from experience, the task of having a project's viability rubber stamped by management is not an
easy one. Managers are very often faced with the dilemma of choosing one of several projects. These projects may all
be of equal importance, effectively competing for the same resources.
Many companies with limited resources use capital rationing - a method of ranking projects in order to allocate the
available funds in the best way. In other words, management selects the project which will result in maximizing
shareholders' wealth - where the additional benefits exceed the project cost.
How do you think management goes about making its investment decisions? There is a three-stage decision-making
process that management can follow.
At the proposal stage, you investigate the feasibility of the investment and submit a short proposal for inclusion in the
capital budget.
At the appraisal stage, you evaluate the proposed project in more detail using a range of project appraisal techniques.
At the approval stage, senior management determines the source of capital to be used to fund the project and formally
allocates funds to it.
Project appraisal is the process of evaluating a proposed project to assess its feasibility and long-term financial benefit
to a company.

Steve and Jenny need to carry out a more detailed long-term analysis of their project's viability. They decide to
concentrate on stage two of the investment decision-making process.
Net present value
What is the future cash flow of this project worth today? It is arrived by taking into account of money value today
versus future money value taking in to consideration of inflation, returns etc

Pay back period.

When the future cash flow to turn positive againt the proposed investment
ROI
What will be the rate of return
Internal rate of return
Tells you how much your cost of capital increase before you incur loss

Before looking in detail at the four project appraisal techniques, you must first consider the main financial variables
required for a project appraisal.
Initial capital outlay
Expected useful economic life of the project
Estimate of the residual value of assets at the end of the project's useful economic life
Amounts and timing of all cost and revenue components associated with the project
elevant cost of financing the project
Likely estimates of variation for each of the above variables
Steve and Jenny cannot generate an appraisal for their project without first gathering the above data. In reality, a cross-
disciplinary team with representatives from various departments is best suited to a project such as this. Steve and
Jenny's project appraisal is only as good as the input data they use.
Now for a look at net present value (NPV), the first of the four project appraisal techniques. This technique allows you
to compare the value of money now with the value of money in the future, taking inflation and return into account.

Put simply, you're asking yourself what the future cash flow of your project is worth today. This is why NPV should
only consider future costs that are unique to the project. Any previous costs associated with other production lines or
projects are irrelevant.

With this technique, you're aiming for a positive result. A negative result means that cash flows are negative and that
you should probably reject the project.
Steve and Jenny will design the new line to serve ComITT for a period of four years, the expected useful economic life
of the project.

Before calculating the NPV, they first need to determine how much the additional line will cost. After consulting with
colleagues and plant equipment suppliers, they believe that this will be a one-off cost of $3,300,000.

They then decide that the additional storage cost of raw materials to support the new line is irrelevant to their
calculations. This is because ComITT has little stock on hand, instead calling it in from a third party supplier as needed.
However, they must spend $360,000 per year to maintain the line in terms of parts and labor.
After discussions with the owner of the factory leased by ComITT, Steve and Jenny also calculate that at the end of this
period, the additional production line in the factory can be valued at $200,000, the residual value of this asset.

In terms of cash flow, they expect this new line to take ComITT's revenues from $40,000,000 to $52,000,000 per
annum. How did they calculate this increase?
They expect the new line to increase capacity from 50,000 to 65,000 units per year. ComITT is currently marketing its
computers at $800 each. Therefore, 15,000 units at $800 each will generate a revenue of $12,000,000 per annum.
teve and Jenny also anticipate production costs of $9,250,000 per annum.

They arrived at this figure by multiplying 15,000 units by $550 - the variable cost of each computer. Then they added
$1,000,000 in fixed costs to the result, giving Steve and Jenny production costs of $9,250,000 per annum for their
project.

However, they know that increased competition may affect revenue figures through years 2 to 4. As a result, they agree
with management to decrease revenue expectation at a flat rate of 6 percent per annum, starting in year 2. Also, due to
decline in demand, they agree to decrease production in years 2 and 3 by 10 percent. However, year 4 is to remain at
year 3 level
With these anticipated changes in revenue and production levels through years 2 to 4, take a look at the revised revenue
and expenditure figures. How did Steve and Jenny go about calculating these figures?

Steve and Jenny now have sufficient information to work out the net cash flow for each year. This is simply a matter of
totaling the figures in each column.
Steve and Jenny then consult their financial controller, who advises them that interest rates, currently at 6 percent, are
expected to rise next year to 7 percent, and then to 8 percent the following year, before dropping back to 6 percent.
Using discounted cash flow tables, they calculate the discount factor for each year.There's also the risk of interest rates
rising as high as 10 percent in year 4.
As you can see, Steve and Jenny have all the necessary figures to carry out their actual NPV calculation. See if you can
help them.

In order to get the present value for each year in the four-year period, Steve and Jenny multiply the net cash flow for
each year by its discount factor. Then, they total the present value for each year to give them an NPV calculation of
$748,181. So far, this looks like a good investment. However, Steve and Jenny have some more road to travel before
they complete their long-term analysis.
Now that you know what payback period tells you about your project, turn your attention to calculating it. Take a look
at the ComITT figures.
First, look for the last year in which the cumulative cash flow is negative (year 1) and record the negative balance at the
start of that year (-$1,065,350).

Then, divide it by the discounted cash flow from the following year ($1,171,519).

Your calculation, should give a payback period of one year and 11 months for this project. This is a very positive result
as, for some projects, it can take years to achieve payback. Steve and Jenny are encouraged by this.
So far, you've helped Steve and Jenny to calculate two things: what the future cash flow of their project is worth today
and how long it will take them to earn back their investment. Now they need to find out what the return on their
investment will be. How can they go about answering that question?

They can use a third project appraisal technique called the accounting rate of return (ARR). ARR is also referred to as
return on investment (ROI) and return on capital employed (ROCE).

ARR will give them an approximate calculation of their project's net profits.
ow for the actual rate of return. To calculate this, divide the average accounting profit by the average capital employed
and then multiply your result by 100.

Average accounting profit is the net yearly cash flow less depreciation, divided by the project life. Depreciation is the
project cost less the scrap value divided by the project life. In this case, ($3,300,000 - $200,000)/4 gives depreciation of
$775,000.

Subtracting $775,000 from the net yearly cash flow, tallying the figures, and dividing the result by four, gives an
average accounting profit of $358,628.
The average capital employed is the second part of the equation. This is the cost of the project plus the scrap value
divided by two.

With a project cost of $3,300,000 and scrap value of $200,000, Steve and Jenny arrive at an average capital employed
of $1,750,000 for their project.
Now they're ready to calculate the ARR. Dividing the average accounting profits ($358,628) by the average capital
employed ($1,750,000), and multiplying the result by 100 gives them an ARR of 20 percent.

Before Steve and Jenny can say that they've completed their project proposal analysis, they must look at one final
technique - the internal rate of return (IRR).

Using this technique provides an answer to the question 'How much can your cost of capital increase before you incur a
loss?'

Put simply, this is the maximum rate of discount you can use to finance the project without making a loss from it.

You're looking for the rate at which the present value of cash inflows exactly equals the capital outlay. This is the rate
at which you'll have an NPV of zero.
Using discount rates of 10 percent and 30 percent, Steve and Jenny come up with the following information:

They transfer this information to the formula. As you can see, the highest discount rate they can use to finance their
project before incurring a loss is 23 percent.
Before writing up their proposal, Steve and Jenny want to take some time to test how robust their model is. This
process is known as sensitivity analysis.

This is a more detailed appraisal of how a project's performance may vary when faced with changes in the key
assumptions on which projections were based.

As we continue, you will see the impact of changing interest rates on Steve and Jenny's project in year 4. However, in
reality it's not that simple. In reality, they would also test potential changes in the cost of raw materials and
maintenance, drops in sales and revenues, and changes in market size, looking for the key sensitivity factors that could
affect their project's success.
Remember when the financial controller told Steve and Jenny that interest rates would drop to 6 percent in year 4?
Using this discount rate, they calculated an NPV of $748,181 for their project.
Now they want to calculate the NPV using a 10 percent discount rate. Remember when the financial controller told
Steve and Jenny that interest rates would drop to 6 percent in year 4? Using this discount rate, they calculated an NPV
of $748,181 for their project.

Now they want to calculate the NPV using a 10 percent discount rate.
As you can see, an increase of 10 percent means applying a discount rate of 0.683 rather than 0.792. Hence, the
project's NPV drops from the original calculation of $748,181 to a revised $722,983. This is a decrease of $25,198.

While $25,198 is a large amount of money, Steve and Jenny still believe that their model is robust enough to submit to
management.
You helped Steve and Jenny to carry out a long-term analysis of their project proposal using four project appraisal
techniques. Now it's time to test how well you employ those techniques using your own project proposal as a basis.