AQA A-Level Business (7138)

## Learning Outcomes

- Understand what strategic investment decisions are and why they matter to long-term business strategy
- Calculate and interpret payback period, average rate of return (ARR) and net present value (NPV)
- Distinguish clearly between cash flow, profit, present value and time value of money
- Explain the strengths and weaknesses of each investment appraisal method
- Evaluate investment decisions using both quantitative and qualitative evidence
- Structure higher-mark answers that compare options and reach a justified judgement

## AQA A-Level Business (7138) Syllabus

For the AQA A-Level Business (7138), you are expected to understand strategic investment decisions, with a focus on the following syllabus points:

- Know that strategic investment decisions are long-term choices involving major capital expenditure and risk
- Identify the purpose of investment appraisal in assessing whether an investment project is worthwhile
- Calculate payback period, including part-year payback where recovery happens during a year
- Calculate average rate of return (ARR) using **average annual profit ÷ initial cost of investment × 100**
- Calculate net present value (NPV) using discounted cash flows and apply the accept/reject rule
- Explain the difference between profit-based and cash-flow-based appraisal methods
- Assess why businesses should use qualitative factors as well as quantitative data
- Evaluate which method may be most useful in different business contexts, such as cash shortages or uncertain markets

## Test Your Knowledge

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, look more closely at that area during your revision._

1. What is meant by a strategic investment decision?
2. How do payback period and ARR measure different things?
3. Why does NPV use discount factors?
4. Which appraisal method is usually best for a business worried about liquidity?
5. Why might the highest numerical result not always lead to the best business decision?

## Introduction

Strategic investment decisions are major long-term choices about where a business commits its money. Typical examples include buying new machinery, opening a new site, investing in technology, expanding capacity or entering a new market. These decisions are expensive, risky and often hard to reverse, so they need careful analysis.

For AQA A-Level Business, this topic is not just about doing calculations. You also need to explain what the figures mean, compare methods, and judge whether an investment fits the business's objectives, resources and external environment.

> **Key Term: strategic investment decisions**
> Long-term decisions involving major capital expenditure that affect the future scale, direction and risk of a business.

### Why businesses use investment appraisal

Businesses rarely invest large sums based on instinct alone. They usually estimate future cash flows and profits, then apply investment appraisal techniques to judge whether a project looks worthwhile.

> **Key Term: investment appraisal**
> The use of quantitative techniques to assess whether an investment project is financially worthwhile.

The three core methods are:

- **payback period**
- **average rate of return (ARR)**
- **net present value (NPV)**

Each method answers a slightly different question:

- **Payback** asks: how quickly do we get our money back?
- **ARR** asks: how profitable is the project on average?
- **NPV** asks: what are the future cash flows worth in today's money, and do they exceed the initial cost?

A strong business answer links these methods to strategy. For example, a supermarket facing falling cash reserves may give more weight to payback. A business trying to maximise long-term shareholder value may focus more on NPV.

> **Key Term: initial investment**
> The amount spent at the start of a project, also called the initial outlay.

Strategic decisions should also fit the wider direction of the business. A project with attractive figures may still be rejected if it clashes with corporate objectives, stretches management capacity, or enters a market with weak demand.

> **Test Tip:** In exam answers, do not describe investment appraisal in isolation. Always link the numbers to the business context, such as growth aims, market uncertainty, competitive pressure or cash flow problems.

### Payback period and ARR

Payback period measures how long it takes for cumulative net cash inflows to recover the initial investment.

> **Key Term: payback period**
> The time taken for cumulative net cash inflows to recover the initial investment.

A shorter payback is usually preferred. This is especially useful when:

- the business has limited cash
- the market is fast-changing
- managers want to reduce risk
- survival is a bigger priority than long-term return

Worked example:

A business invests **£50,000** in new equipment.

Expected net cash flows:

- Year 1: **£15,000**
- Year 2: **£20,000**
- Year 3: **£18,000**
- Year 4: **£10,000**

Step 1: Calculate cumulative cash flow

- End of Year 1: **£15,000**
- End of Year 2: **£35,000**
- End of Year 3: **£53,000**

The investment is recovered during Year 3.

Step 2: Work out how much is still unrecovered after Year 2

- **£50,000 - £35,000 = £15,000**

Step 3: Work out what fraction of Year 3 is needed

- **£15,000 ÷ £18,000 = 0.8333 years**

Step 4: Convert to months

- **0.8333 × 12 = 10 months**

Payback period = **2 years 10 months**

Average rate of return focuses on profitability, not speed of cash recovery.

> **Key Term: average rate of return (ARR)**
> The average annual profit from an investment as a percentage of the initial cost of investment.

AQA formula:

ARR = (average annual profit ÷ initial cost of investment) × 100

Using the same project:

Total net cash flows over 4 years:

- **£15,000 + £20,000 + £18,000 + £10,000 = £63,000**

Total profit over the project life:

- **£63,000 - £50,000 = £13,000**

Average annual profit:

- **£13,000 ÷ 4 = £3,250**

ARR:

- **(£3,250 ÷ £50,000) × 100 = 6.5%**

ARR = **6.5%**

Payback and ARR side by side:

- **Payback** uses **cash flow** and focuses on speed
- **ARR** uses **profit** and focuses on percentage return
- **Payback** ignores returns after the payback point
- **ARR** uses the whole life of the project but ignores timing

Common student errors:

- using total cash flow instead of cumulative cash flow for payback
- forgetting to convert part of a year into months
- using the wrong ARR denominator; for AQA use **initial investment**, not average investment
- confusing profit with cash flow
  > **Test Tip:** If the exam asks for ARR, write the formula first. This helps avoid the common mistake of dividing by average investment instead of initial investment.

Strengths and weaknesses:

Payback strengths

- easy to calculate
- useful for cash-poor firms
- reduces exposure to uncertainty by rewarding faster recovery

Payback weaknesses

- ignores profitability
- ignores cash flows after payback
- may encourage short-termism

ARR strengths

- easy to compare projects as percentages
- focuses on profitability
- uses all project years

ARR weaknesses

- ignores timing of returns
- ignores time value of money
- depends on forecast profit figures

### Net present value (NPV)

NPV improves on the earlier methods by recognising that money received in the future is worth less than money received now. This is because current money could be used elsewhere to earn a return.

> **Key Term: net present value (NPV)**
> The total present value of future net cash inflows minus the initial investment.
>
> **Key Term: time value of money**
> The idea that money received now is worth more than the same amount received in the future.
>
> **Key Term: present value**
> The value today of a future cash flow after discounting.
>
> **Key Term: discount factor**
> A multiplier used to convert a future cash flow into its present value.

Present value formula:

Present value = cash flow × discount factor

Discount factor formula:

1 ÷ (1 + r)^n

where:

- **r** = discount rate
- **n** = number of years ahead

Worked example:

Initial investment = **£40,000**

Forecast net cash inflows:

- Year 1: **£12,000**
- Year 2: **£15,000**
- Year 3: **£18,000**

Assume discount factors are:

- Year 1: **0.91**
- Year 2: **0.83**
- Year 3: **0.75**

Step 1: Discount each year's cash flow

- Year 1 present value = **£12,000 × 0.91 = £10,920**
- Year 2 present value = **£15,000 × 0.83 = £12,450**
- Year 3 present value = **£18,000 × 0.75 = £13,500**

Step 2: Add total present value of inflows

- **£10,920 + £12,450 + £13,500 = £36,870**

Step 3: Subtract initial investment

- **£36,870 - £40,000 = -£3,130**

NPV = **-£3,130**

Decision rule:

- **positive NPV**: usually accept
- **negative NPV**: usually reject
- if comparing options, the **higher positive NPV** is usually preferred

Why NPV is often seen as the strongest financial method:

- it uses all project cash flows
- it recognises timing
- it includes the time value of money
- it gives a direct accept/reject signal

But NPV still has limits:

- future cash flows are only forecasts
- the chosen discount rate may change the result
- strategic benefits such as stronger brand image or improved quality may not show fully in the numbers

Common student errors:

- forgetting to subtract the initial investment at the end
- discounting the initial investment when it is already a present-day outflow
- using profit instead of cash flow
- adding undiscounted and discounted values together incorrectly

### Using qualitative factors and making evaluative judgements

No good business makes a strategic investment decision using only one number. Managers should combine appraisal results with qualitative factors.

> **Key Term: qualitative factors**
> Non-numerical issues that affect a decision, such as staff impact, brand image, strategic fit or market uncertainty.

Important qualitative factors include:

- **business objectives**: is the aim growth, survival, profit or diversification?
- **financial position**: can the business afford the risk?
- **market conditions**: is demand growing or falling?
- **competition**: will rivals respond strongly?
- **impact on staff**: will automation damage morale or create resistance?
- **quality and customer service**: could the investment improve reputation?
- **strategic fit**: does the project match the mission and long-term direction?
- **risk and uncertainty**: how reliable are the forecasts?

For example, a new customer service centre may have a slower payback than an automated machine, but it might improve customer loyalty and reduce complaints. That could support long-term market share even if the short-term numbers are slightly weaker.

A strong evaluation often uses the structure:

- **On the one hand**: one method or option looks attractive
- **On the other hand**: another method or contextual factor points elsewhere
- **It depends on**: the business's objectives, cash position, market risk and timescale

If a firm is highly geared or cash-poor, a short payback may matter most. If the business is financially secure and wants long-term value, NPV may deserve more weight. If the project is strategically necessary, even a weaker short-term result may be accepted.

How to structure an evaluative answer:

Start by comparing the quantitative evidence. State which project has the shorter payback, higher ARR or stronger NPV. Then discuss what those figures imply in context. After that, bring in non-financial issues such as risk, staff effects, strategic fit and market conditions. Finally, make a judgement that is conditional, not absolute. Explain what factor matters most for this business now.

A good judgement sounds like this: the project with the stronger NPV may be best if the business has secure cash flow and seeks long-term returns, but the quicker-payback option may be safer if liquidity is tight or demand is uncertain.

> **Test Tip:** For 16- or 20-mark strategy questions, do not finish with a generic judgement like "both have advantages and disadvantages". Choose one option, then explain why that choice depends on the business context.

## Key Point Checklist

_This article has covered the following key knowledge points:_

- Strategic investment decisions are long-term, expensive and difficult to reverse
- Investment appraisal helps businesses assess whether a project is financially worthwhile
- Payback period measures how quickly the initial investment is recovered from net cash inflows
- Shorter payback is usually preferred, especially when liquidity and risk matter
- ARR measures average annual profit as a percentage of the initial cost of investment
- For AQA, ARR uses **initial investment** as the denominator
- ARR is profit-based, while payback and NPV are cash-flow-based
- NPV uses discounted cash flows to reflect the time value of money
- A positive NPV usually means a project should be accepted
- NPV is often seen as the strongest financial method, but it still depends on forecasts and assumptions
- Businesses should combine quantitative evidence with qualitative factors such as strategic fit, staff impact and market conditions
- High-mark answers compare methods, apply them to the context and reach a justified judgement

## Key Terms and Concepts

- strategic investment decisions
- investment appraisal
- initial investment
- payback period
- average rate of return (ARR)
- net present value (NPV)
- time value of money
- present value
- discount factor
- qualitative factors


Strategy - Strategic investment decisions