What are Capital Investment Decisions?

We will learn more about the capital investment decisions. The efficient allocation of capital is the most important finance function in the modem times. It involves decisions to commit the firm’s funds to the long-term assets. Such decisions are of considerable importance to the firm since they tend to determine its value and size by influencing its growth, profitability and risk. In this chapter, we shall discuss the nature of investment decisions and the criteria for investment analysis. We shall also provide a comparison of the various investments criteria to indicate the most consistent criterion.

The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions. A capital budgeting decision may be defined as the firm’s decision to invest its current funds most efficiently in the long-term assets ill anticipation of an expected flow of benefits over a series of years. The long-term assets are those, which affect the firm’s operations beyond the one-year period. The firm’s investment decisions would generally include expansion, acquisition, modernization and replacement of the long-term assets. Sale of a division or business (divestment) is also analyzed as an investment decision. Activities such as change in the methods of sales distribution, or undertaking an advertisement campaign or a research and development programme have long term implications for the firm’s expenditures and benefits, and therefore, they may also be evaluated as investment decisions. It is important to note that investment in the long- term assets invariably requires funds to be tied up in the current assets such as inventories and receivables. As such, investment in fixed and current assets is one single activity.

The following are the features of capital investment decisions:

  • The exchange of current funds for future benefits.
  • The funds-are invested in long-term assets.
  • The future benefits will occur to the firm over a series of years

It is significant to emphasize those expenditures and benefits of an investment should be measured in cash. In the investment analysis, it is cash flow, which is important, not the accounting profit. It may also be pointed out that investment decisions affect the firm’s value. The firm’s value will increase if invest- mints are profitable and add to the shareholders’ wealth. Thus investments should be evaluated on the basis of a criterion, which is compatible with the objective of the shareholders’ wealth maximization. An investment will add to the shareholders’ wealth if it yields benefits in excess of the minimum benefits as per the opportunity cost of capital. In this chapter, we assume that the investment project’s opportunity cost of capital is known. We also assume that the expenditures and benefits of the investment are known with certainty.

There may be various criteria for selecting the right and appropriate decision for capital investment. For example, a firm may emphasize on the projects that promise for the immediate return while some other firms may insist on the projects that ensure long term growth. The major goal of capital investment decision is to increase the value of firm by undertaking right project at right time.

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