Key Issues in Making Investment Decisions

If a business wishes to grow, it needs to invest.

The cash spent on investment in a business is normally referred to as "capital expenditure". This can be contrasted with spending on day-to-day operations (e.g. paying for materials, staff costs) which is known as "revenue expenditure".

The distinction between capital and revenue expenditure is quite an important one.

The main difference is that capital expenditure is on non-current assets which have an "economic life" in the business – they are intended to be kept, rather than sold or turned into products.

There are several reasons why a business needs to invest in capital expenditure:

• To add extra production capacity
• To replace worn-out, broken or obsolete machinery and equipment
• To support the introduction of new products and production processes
• To implement improved IT systems
• To comply with changing legislation & regulations

The problem for most businesses is that the finance available for capital investment is limited. There are usually more possible capital investment opportunities than there is available finance. So choices have to be made and some capital investments rejected.

A key consideration with capital investment is the rate or return that an investment will make. This is vital because the owners of the business look to management to maximise their return. If the business cannot earn an acceptable return, then the owners would be better off taking their cash out of the business and investing it elsewhere.

There are several methods available which help management make the decisions about which projects to invest in, which are described and illustrated further below:

• Payback
• Net present value ("NPV")
• Average rate of return ("ARR")