OxfordAQA A-Level Business: Deciding on a strategic investment (9725)

This guide follows the OxfordAQA International AS and A-level Business (9725) specification, Version 1.1, for International AS exams May/June 2027 onwards and International A-level exams May/June 2028 onwards. It teaches section 3.4.3 Deciding on a strategic investment, which is International A-level only content in the 3.4 Business strategy block. Anyone part-way through the older 9625 course should rely on the 9625 document rather than this page. Every business on this page is invented.

Alongside this guide sit the condensed revision notes and original practice questions. Course-wide pages: the 9725 course hub and the printable 9725 checklist. A quick check of where you stand is available through the free diagnostics.

Outcomes in 3.4.3

Content heading	Skill required	Status
Decision trees	Complete, amend and interpret simple decision trees	International A-level only
Decision trees	Calculate expected values and net gain	International A-level only
Decision trees	Explain the limitations and the value of decision trees	International A-level only
Investment decisions	Explain the meaning and significance of investment	International A-level only
Investment appraisal	Calculate and interpret payback period, average rate of return and net present value	International A-level only
Factors influencing investment	Weigh investment criteria, non-financial factors, risk, uncertainty, business confidence and opportunity cost	International A-level only

Which paper. Unit 4: Business strategy examines all of section 3.4. It is a 1 hour 45 minute paper with 80 marks, worth 30% of the International A-level, built around two case studies. The specification says each case study opens with a 4-mark calculation, so an expected value or appraisal figure fits there naturally.

1. Decision trees

A decision tree is a diagram that sets out a business’s options, the possible outcomes of each, their probabilities and the financial results.

The symbols

• A square is a decision point: the business chooses which branch to take.
• A circle is a chance node: what happens next is outside the firm’s control.
• Each branch leaving a circle carries a probability. The probabilities leaving one circle must add up to 1.
• The figure at the end of each branch is the financial outcome (often called the payoff).

Two calculations

Expected value (EV) = sum of (probability x financial outcome) for each branch
Net gain            = expected value - cost of the option

Work from right to left: find the expected value at each circle, then subtract the cost at the square. The option with the highest net gain is the one the tree recommends.

Worked example: Kestrelby Coffee Roasters

Kestrelby roasts and sells coffee beans online. It has two growth options.

• Option A: launch a monthly subscription service. Cost £45,000. There is a 0.65 chance it succeeds, earning £130,000, and a 0.35 chance it does poorly, earning £20,000.
• Option B: open a tasting counter in a shopping centre. Cost £70,000. There is a 0.55 chance of strong footfall, earning £180,000. The probability of weak footfall is not given; weak footfall would earn £50,000.
• Kestrelby could also do nothing, with a net gain of £0.

Step 1: complete the tree. Probabilities at one chance node sum to 1, so the chance of weak footfall = 1 − 0.55 = 0.45.

Step 2: expected values.

EV of A = (0.65 x 130,000) + (0.35 x 20,000)
        = 84,500 + 7,000 = £91,500
EV of B = (0.55 x 180,000) + (0.45 x 50,000)
        = 99,000 + 22,500 = £121,500

Step 3: net gains.

Net gain of A = 91,500 - 45,000 = £46,500
Net gain of B = 121,500 - 70,000 = £51,500

Step 4: interpret. On these figures Kestrelby should choose Option B, because it has the higher net gain (£51,500 against £46,500), and both beat doing nothing. The gap is only £5,000, though, so small errors in the estimates could reverse it. The worst case for B is a loss of £20,000 (50,000 − 70,000) and for A a loss of £25,000 (20,000 − 45,000).

Step 5: amend the tree. Suppose the shopping centre raises its fit-out charges and Option B now costs £80,000. Its net gain falls to 121,500 − 80,000 = £41,500, below Option A’s £46,500. The recommendation switches to A. Amending a tree in this way shows how sensitive a decision is to one estimate.

An expected value is a weighted average: Option B will actually earn £180,000 or £50,000, never £121,500.

Limitations of decision trees

• The probabilities are often estimates or guesses, especially for new products or markets.
• The financial outcomes are forecasts, and they may be biased by managers who favour one option.
• The method ignores the timing of returns, so it does not allow for the time value of money.
• Qualitative factors, such as staff morale, ethics or brand image, are left out.
• Expected value ignores the business’s attitude to risk. A small firm may not be able to survive the worst outcome, however good the average.

The value of decision trees

• They force managers to set out every option, including doing nothing.
• They make managers think about what could go wrong, not just the hoped-for result.
• They can be amended quickly to test “what if” questions, as in Step 5.

Trees are most useful when probabilities rest on reliable past data.

2. The meaning and significance of investment

Investment means spending money now on assets, such as machinery, buildings, vehicles, technology or research, in the hope of earning greater returns in the future. A strategic investment is large and long term and shapes the direction of the whole business, such as a new factory.

Investment decisions are significant because they:

• usually commit large sums of money that are hard to recover if the project fails;
• tie the business to a course of action for many years;
• affect future capacity, costs and competitiveness;
• may need external finance, which brings interest costs or loss of control.

So businesses use investment appraisal to judge whether a project is financially worthwhile.

3. Investment appraisal

Worked example: Thornvale Print Studio

Thornvale is considering a new large-format printing press costing £222,000. It expects the press to last five years and to generate these net cash flows:

Year	Net cash flow (£)	Cumulative cash flow (£)
0	(222,000)	(222,000)
1	48,000	(174,000)
2	66,000	(108,000)
3	72,000	(36,000)
4	72,000	36,000
5	75,000	111,000

Payback period

The payback period is how long a project’s net cash inflows take to cover what was spent at the start.

At the end of year 3 Thornvale is still £36,000 short. Year 4 brings £72,000, which we assume arrives evenly through the year.

Months into year 4 = (shortfall / year 4 cash flow) x 12
                   = (36,000 / 72,000) x 12 = 6 months
Payback period     = 3 years 6 months

Interpretation. A shorter payback means the money is at risk for less time. Payback suits firms short of cash or facing fast change, but it ignores cash flows after the payback point and says nothing about profitability.

Average rate of return (ARR)

The average rate of return shows the average annual profit from a project as a percentage of the initial investment.

Total net cash inflows  = 48,000 + 66,000 + 72,000 + 72,000 + 75,000 = 333,000
Total profit            = 333,000 - 222,000 = 111,000
Average annual profit   = 111,000 / 5 years = 22,200
ARR = (average annual profit / initial investment) x 100
    = (22,200 / 222,000) x 100 = 10%

Interpretation. ARR can be compared with the return from other projects or the interest rate on a loan. It uses every year’s cash flow. However, it treats a pound in year 5 as worth the same as a pound in year 1, and a high average can hide a slow start.

Net present value (NPV)

Money received in the future is worth less than the same sum today, because money held now could be saved to earn interest. This is the time value of money. Discounting converts future cash flows into their present value using a discount factor based on a chosen discount rate.

Discount factor (year n, rate r) = 1 / (1 + r)^n
Each year's present value         = that year's cash flow x its factor
NPV = sum of the present values - the initial cost

Thornvale uses a 7% discount rate. With factors rounded to three decimal places:

Year	Net cash flow (£)	Discount factor (7%)	Present value (£)
1	48,000	0.935	44,880
2	66,000	0.873	57,618
3	72,000	0.816	58,752
4	72,000	0.763	54,936
5	75,000	0.713	53,475
		Total	269,661

NPV = 269,661 - 222,000 = £47,661

Interpretation. A positive NPV means the project earns more than the discount rate, so it adds value. A negative NPV means it earns less. NPV is the only one of the three methods that allows for the time value of money. But the answer depends heavily on the discount rate chosen, and it is harder for non-specialists to follow.

Comparing the three methods

Method	Main strength	Main weakness
Payback	Quick; focuses on cash and on risk	Ignores cash after payback and profitability
ARR	Uses all cash flows; easy to compare with an interest rate	Ignores the timing of cash flows
NPV	Allows for the time value of money	Result depends on the discount rate chosen

All three rely on forecast cash flows, which grow less reliable further ahead.

4. Factors influencing investment decisions

Investment criteria. These are the targets a business sets in advance that a project must meet, such as a maximum payback period, a minimum ARR or a positive NPV at a set discount rate. Suppose Thornvale requires payback within 4 years, an ARR of at least 12% and a positive NPV at 7%. The press passes on payback (3 years 6 months) and NPV (£47,661) but fails on ARR (10%). Managers must then judge which criterion matters most. If cash is tight, payback may carry most weight.

Non-financial factors. These include effects on employees (training, job losses, morale), the environment, the local community and brand image, and fit with the firm’s mission. A project with a lower NPV may win because it fits the strategy better.

Risk. Risk exists where the possible outcomes can be identified and given probabilities, often from past data. Decision trees and expected values handle risk.

Uncertainty. Uncertainty exists where outcomes, or their chances, cannot be measured, such as a sudden new competitor or a change in government policy. Numerical methods cannot capture it, so managers rely on judgement and on keeping the investment flexible.

Business confidence. This is how optimistic managers feel about future trading conditions. When confidence is high, firms expect demand to grow and invest more readily. When it is low, they delay projects, even ones with a positive NPV, because they doubt the cash flow forecasts.

Opportunity cost. This is the next best alternative given up. Money spent on the press cannot also fund a new website or repay a loan, so a project should be compared with the best alternative use of the money.

Common errors

• Forgetting to subtract the cost of an option, so the expected value is compared instead of net gain.
• Probabilities at a chance node that do not add up to 1 after the tree has been amended.
• Writing payback as 3.3 years when the question wants years and months.
• Calculating ARR with total profit instead of average annual profit.
• Forgetting to subtract the initial investment when finding NPV.
• Treating a positive NPV as automatically “accept” without discussing risk, uncertainty and non-financial factors.

Where next

• Quick recall: deciding on a strategic investment revision notes
• Test yourself: deciding on a strategic investment practice questions
• Find weak areas: all free 10-minute diagnostics

Official syllabus

OxfordAQA International AS and A-level Business (9725) specification, Version 1.1, for International AS exams May/June 2027 onwards and International A-level exams May/June 2028 onwards. Published by OxfordAQA.