Investment-Decisions

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Exam code:J204

Types of investment decisions

Over time, businesses need to buy or upgrade assets such as machinery, vehicles or property
Businesses may need to buy, renovate, upgrade or extend land and buildings to house their operations
- Examples include factories, office space, retail stores and warehouses
- Owning the land and buildings gives them control over these spaces
- Machinery such as production lines, tools and IT equipment are used in manufacturing and administration processes
  - Initial investments in machinery, as well as upgrades, help to reduce average production costs, increase quality and maintain efficiency
Businesses also make investments in research and development activities, including:
- Market research
- Inventing new materials and processes
- Developing prototypes
In some cases, a business may want to keep retained profit for future use by placing it in a savings account, and expect it to gain value

Average rate of return (ARR)

The Average Rate of Return helps a business judge whether an investment will be worthwhile
- It compares the initial cost of an investment with the average profit likely to be generated each year
The ARR is expressed as a percentage and calculated using the formula:

$Average space r ate space of space return space equals space fraction numerator Average space yearly space profit over denominator Cost space of space investment end fraction space cross times 100 space space space space space space$

Worked Example

Creative Frames, a small artwork framing business based in Lowestoft, is considering an investment of £40,000 in new machinery. Megan, the business owner, believes that total returns over a 6-year period will be £76,000

Calculate the Average Rate of Return of the proposed investment. [4 marks]

Step 1: Deduct the cost of the investment from the total forecasted returns

$£ 76 comma 000 minus £ 40 comma 000 space equals space £ 36 comma 000$ [1]

Step 2: Divide the outcome by the number of years of use to determine the average yearly profit

$£ 36 comma 000 space divided by space 6 space years space equals £ 6 comma 000$ [1]

Step 3: Substitute the values into the ARR formula

<img alt=”ARR space equals space fraction numerator Average space yearly space profit over denominator Cost space of space investment end fraction space straight x space 100 equals space fraction numerator £ 6 comma 000 over denominator £ 40 comma 000 end fraction space straight x space 100 equals space 0.15″ data-mathml=”<math style=”font-family:Arial” ><semantics><mstyle mathsize=”14px”><mi>ARR</mi><mo> </mo><mo>=</mo><mo> </mo><mfrac><mrow><mi>Average</mi><mo> </mo><mi>yearly</mi><mo> </mo><mi>profit</mi></mrow><mrow><mi>Cost</mi><mo> </mo><mi>of</mi><mo> </mo><mi>investment</mi></mrow></mfrac><mo> </mo><mi mathvariant=”normal”>x</mi><mo> </mo><mn>100</mn><mspace linebreak=”newline”/><mspace linebreak=”newline”/><mo>=</mo>

Business GCES OCR

Investment-Decisions

Types of investment decisions

Average rate of return (ARR)

Worked Example

Responses