W 2: Investment Decisions
Like all other companies Cameron Balloons are continually re-assessing their production methods to ensure they remain as productive as possible. A part of this process is to assess whether investment has to be made in new production technologies. In the case of Cameron’s this choice is illustrated by the decision over whether to mechanise the cutting process. Why not have a go at this worksheet to see what you would do?
N.B. For reasons of commercial sensitivity, the figures given are not necessarily the ones Cameron’s may precisely face.
A printable version of this worksheet is available for filling in answers.
Step 1 - How do we decide?
The fabric for the balloon envelopes 
is currently cut on cutting tables by hand. See the explanation of production for more detail on this. There are now moving-bed cutters available that will automate this process, and cut the fabric according to computer templates. There are two main types of cutter - one uses a high powered water jet to cut the fabric and the other a laser.
What advantages might there be from using these new machines?
What disadvantages might there be?
Step 2 - Is it worth it?
Clearly a big constraint in deciding whether to invest in these new machines is their cost. Appropriate machines for Cameron Balloons could cost anywhere from £40,000 to £125,000 depending on how sophisticated they are. Whether or not they are worth it depends on the return that these machines generate.
There are two main techniques for assessing these returns. They are known as the average rate of return and the payback period. Research in your textbook or library to find out what is meant by each of these techniques, and summarise them.
Cameron Balloons have to choose between the cheaper cutting machines that will improve efficiency by a reasonable amount, and the more expensive machines that will have considerably more benefits. Say that the extra income they expect from each is as shown in the table below. Work out the payback period for each of the two options:
| Year |
1 |
2 |
3 |
4 |
5 |
Payback Period |
Machine 1:
£40,000 |
£20,000 |
£16,000 |
£14,000 |
£9,000 |
£6,000 |
|
Machine 2:
£125,000 |
£50,000 |
£45,000 |
£25,000 |
£20,000 |
£15,000 |
|
(N.B. These figures are for illustration only - they are not necessarily realistic commercially)
Which machine has the shorter payback period?
Why do you think that the extra income from the new machines declines each year?
Use the income figures from the table above and the blank table below to calculate the average rate of return for each of the machines:
| |
Total Income from Machine |
Cost of Machine |
Net profit from machine (Income - Cost) |
Profit per year (Net profit / number of years) |
ARR (profit per year / cost x 100) |
Machine 1:
£40,000 |
|
£40,000 |
|
|
|
Machine 2:
£125,000 |
|
£125,000 |
|
|
|
What is the average rate of return for each of the machines?
Go to the Treasury site or the Bank of England site and try to find the current rate of interest.
How do the rates of return on the two machines compare with the current rate of interest?
Why is it important for Cameron’s that the rate of return on the machine they choose is significantly greater than the market rate of interest?
On the basis of these two measures, which of the two machines should Cameron’s choose to buy (if either)? Justify your answer with reference to the figures.
Step 3 - Is the future worth as much?
With the methods of investment appraisal we have used above we have assumed that an income in 5 years time is worth just as much as now. However, this is not necessarily accurate. If you have £10,000 now and invest it in the bank, it will be worth more in 5 years time. Therefore £10,000 in five years time will be worth less now.
Try these examples (assume a rate of interest of 10%):
- Would you rather have £10,000 now or £11,100 in 3 years time?
- Would you rather have £50,000 now or £90,000 in 5 years time?
N.B. Assume for these questions that your desperate need for cash now does not overrule your sensible and reasoned financial judgement. In other words work out which is the better option financially!!
To take account of this and work out what a future stream of income is worth to a company, we use a technique called discounted cash flow. Discounted cash flow takes the future income and works out what that income would be worth now. To do this you need to "discount" the future money at a given rate of interest. The present value of the money is given by the formula:
| PRESENT VALUE | = | A
(1+R/100)^n
|
where A= the amount of income, R= the rate of interest and n= the number of years
For example - with the above figures, Cameron Balloons estimated that machine 2 would generate an income in 5 year’s time of £15,000. To work out the current value of this, given an average interest rate of 10%, we would do the following:
PRESENT VALUE = £15,000 / (1.1)^5 = £15,000 / 1.61 = £9,316
So £15,000 in 5 years time would be worth the same as £9,316 now.
See if you can apply this technique to the figures given for the machines in Step 2. You may find the table below helpful in doing this:
| |
Income - year 1 - present value |
Income - year 2 - present value |
Income - year 3 - present value |
Income - year 4 - present value |
Income - year 5 - present value |
Total income - present value |
Cost of machine |
Net income |
Machine 1:
£40,000 |
|
|
|
|
|
|
£40,000 |
|
Machine 2:
£125,000 |
|
|
|
|
|
|
£125,000 |
|
N.B. Assume an interest rate of 10%.
Would both machines still be worthwhile, using a discounted cash flow technique of investment appraisal?
Step 4 - Where do they go from here?
Given all the calculations you have done, do you think that Cameron Balloons should proceed with this investment? If so, which machine should they use?
What other decision-making techniques may be helpful to them in trying to decide on this new investment?
