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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.
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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 long-term and expensive. Investment examples include:
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.
It would be rare for a company to make a substantial investment without incurring some debt.
Interestis 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.
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.