Deciding on a strategic investment (A Level) flashcards

Topic 13: Deciding on a strategic investment

Decision trees: decision points and chance nodes

A square is a decision point, where the business chooses between options. A circle is a chance node, where outcomes depend on events outside the firm’s control. Probabilities at one chance node must sum to 1.

An option costs £30,000. It has a 0.3 chance of £80,000 and a 0.7 chance of £25,000. Find the expected value and net gain.

EV = (0.3 × 80,000) + (0.7 × 25,000) = 24,000 + 17,500 = £41,500. Net gain = 41,500 − 30,000 = £11,500.

Decision trees: limitations and value

Limitations: probabilities and outcomes are estimates that may be biased, timing is ignored, few outcomes can be shown, qualitative factors are left out. Value: forces managers to list options (including doing nothing), gives a numerical comparison, can test “what if” changes.

An oven costs £36,000 and returns £12,000, £15,000 and £18,000 in Years 1–3. Find the payback period.

Cumulative: −24,000 (Year 1), −9,000 (Year 2), +9,000 (Year 3). Months into Year 3 = 9,000 ÷ 18,000 × 12 = 6. Payback = 2 years 6 months.

Average rate of return (ARR) in 9725: formula and example (cost £80,000, total net inflows £104,000 over 5 years)

ARR = average annual profit ÷ initial investment × 100. Total profit = 104,000 − 80,000 = 24,000; average = 4,800 a year. ARR = 4,800 ÷ 80,000 × 100 = 6%.

Net present value (NPV): method and example (invest £20,000; flows £9,000, £9,000, £6,000; 5% factors 0.952, 0.907, 0.864)

Multiply each year’s flow by its discount factor, add, then subtract the initial investment. 8,568 + 8,163 + 5,184 = 21,915. NPV = 21,915 − 20,000 = £1,915.

What does a discount factor of 0.907 for Year 2 mean?

£1 received in two years’ time is worth about £0.907 today at that discount rate. Discount factor for year n at rate r = 1 ÷ (1 + r)ⁿ.

Payback vs ARR vs NPV: what each measures

Payback measures speed of return (liquidity). ARR measures profitability but ignores when the cash arrives. NPV allows for the time value of money; positive means the project earns more than the discount rate.

Risk vs uncertainty in investment decisions

Risk: outcomes and probabilities can be estimated, so decision trees help. Uncertainty: outcomes or their chances cannot be measured, so judgement and flexibility matter more than the numbers.

Factors influencing investment decisions (9725)

Investment criteria (targets set in advance), non-financial factors, risk, uncertainty, business confidence (low confidence delays projects even with positive NPVs) and opportunity cost (the best alternative use of the funds).