Download 3.3 E Poor Investment Decisions

AS 91381 (3.3)
Apply business knowledge to address a
complex problem in a given global
business context
PART E – POOR INVESTMENT
DECISIONS
Investment refers to the purchase
of capital goods or any other use
of retained profits that is likely
to earn a return in the future.
Investment is not the same as
saving money in a bank or buying
shares to try to earn dividends.
Investment is the purchase of
productive capacity. For example,
buying equipment or a new factory to
increase capacity, meaning to increase
the amount that can be produced. This
will lead to consumer demand being
met and sales revenue being generated.
Capital investments are usually longterm and expensive. Investment
examples include:
O To replace obsolete, broken or
worn-out machinery and
equipment
O To add extra production capacity
O To support the introduction of
new products and production
processes
O To implement improved IT
systems
O To comply with changing
legislation and regulations
An investment decision should consider
quantitative factors, such as forecasted
cash flows and the profits to be generated.
The investment should either increase
revenue or reduced costs in the long-term.
Qualitative factors will also influence a
firm’s decisions about capital investment.
These include the current and expected
state of the economy, possible impacts on
image and reputation, levels of risk, the
impact on employees, product quality and
service, responsibilities to society and other
external stakeholders.
Changes in Interest Rates
It would be rare for a company to make
a substantial investment without
incurring some debt.
Interest is the cost of borrowing funds.
Changes in interest rates affect the
amount a company will be prepared to
invest. A rise in interest rates increases
the cost of borrowing, so projects
financed this way lose some of their
attractiveness and profit is reduced.
A rise in interest rates is also likely to
reduce total spending in the economy.
This might affect the profitability of an
investment project.
For example, a business may forecast
that investment in new machinery
would be profitable if 30,000 production
units were sold. If sales were projected
to be only 20,000 units due to a
downturn in demand, investing in the
machinery could be unprofitable and
would not go ahead.
The impact of fluctuating interest rates is felt
when borrowing is at a variable interest rate.
For example, a mortgage on buildings may be
taken out at a variable rate of 6% per annum.
When the bank increases or decreases the
interest rate, the business’s interest expense
will increase or decrease accordingly. Loans
and mortgages may be taken out with fixed
rates which guarantee the interest rate for
the period of the agreed term.
If banks increase interest rates on savings,
shelving an investment project in favour of
saving funds in the bank becomes an
attractive option.
Strategic reactions to
interest rate changes
1. If interest rate changes are relatively
small, there is little need for a
business to change its strategy as a
movement of 1 or 2 per cent is
unlikely to have much impact.
2. Companies with high levels of debt
are 'highly geared', and are at risk of
facing financial difficulties if interest
rates rise.
3. Significant falls in interest rates should
stimulate investment by businesses. With
the cost of borrowing much cheaper,
investment projects that in the past may
have been unprofitable now become
profitable.
4. If rises in interest rates are large enough
to cause a sharp downtown in the
economy, businesses will need to change
their strategy if they are in industries most
affected by the downturn. A supermarket
chain is unlikely to see a marked decrease
in sales, whereas an appliance store could
see a large drop in sales.
Consequences of Poor
Investment Decisions
O Cashflow/liquidity problems, including
O
O
O
O
O
O
O
insolvency
Reduced profitability
Loss of shareholder confidence, devaluation
of company
Under-utilisation of new resource
Reduced efficiency/productivity
Loss of competitive advantages
Negative publicity, damage to brand
Lack of consumer/employee trust and
loyalty