Nature and Introduction of Investment Decisions

An efficient allocation of capital is the most important finance function in the modern items. It involves decisions to commit the firms funds to the long term assets. Capital budgeting or investment decisions are of considerable importance to the firm since they tend to determine its value by influencing its growth, profitability and risk. The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions. A capital budgeting decision may be define as the firms decisions to invest its current funds most efficiently in the long term assets in anticipation of an expected flow of benefits over a series of years. The long term assets are those that affect the firms operations beyond the one year period. The firms investment decisions would generally include expansion, acquisition, modernization and replacement of the long term asset. Sale of division or business is also as an investment decision. Decisions like the change in the methods of sales distribution, or an advertisement campaign or a research and development programmed have long term implications for the firms expenditures and benefits, and therefore, they should also be evaluated as investment decisions. It is important to note that investment in the long term assets invariably requires large 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 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.

Types of Investment Decisions

One of the classifications is as follows,

Expansion of existing business Expansion of new business Replacement and moderation

Expansion and Diversification A company may add capacity to its existing product lines to expand existing operation. For example, the Company Y may increase its plant capacity to manufacture more X. It is an example of related diversification. A firm may expand its activities in a new business. Expansion of a new business requires investment in new products and a new kind of production activity within the firm. If a packing manufacturing company invest in a new plant and machinery to produce ball bearings, which the firm has not manufacture before, this represents expansion of new business or unrelated diversification. Sometimes a company acquires existing firms to expand its business. In either case, the firm makes investment in the expectation of additional revenue. Investment in existing or new products may also be called as revenue expansion investment. Replacement and Modernization The main objective of modernization and replacement is to improve operating efficiency and reduce costs. Cost savings will reflect in the increased profits, but the firms revenue may remain unchanged. Assets become outdated and obsolete with technological changes. The firm must decide to replace those assets with new assets that operate more economically. If a Garment company changes from semi automatic washing equipment to fully

automatic washing equipment, it is an example of modernization and replacement. Replacement decisions help to introduce more efficient and economical assets and therefore, are also called cost reduction investments. However, replacement decisions that involve substantial modernization and technological improvements expand revenues as well as reduce costs.

Types of Investment Decisions (2)

Another useful way of classify investments is as follows

Mutually exclusive investment Independent investment Contingent investment

Mutually exclusive investment Mutually exclusive investments serve the same purpose and compete with each other. If one investment is undertaken, others will have to be excluded. A company may, for example, either use a more labor intensive, semi automatic machine, or employ a more capital intensive, highly automatic machine for production. Choosing the semi-automatic machine precludes the acceptance of the highly automatic machine. Independent investment Independent investments serve different purposes and do not compete with each other. For example, a heavy engineering company may be considering expansion of its plant capacity to manufacture additional excavators and addition of new production facilities to manufacture a new product light commercial vehicles. Depending on

their profitability and availability of funds, the company can undertake both investments. Contingent investment Contingent investments are dependent projects; the choice of one investment necessitates undertaking one or more other investment. For example, if a company decides to build a factory in a remote, backward area, it may have to invest in houses, roads, hospitals, etc. For employees to attract the work force thus, building of factory also requires investment in facilities for employees. The total expenditure will be treated as one single investment

Factors influencing investment decision

Capital investment decisions are not governed by one or two factors, because the investment problem is not simply one of replacing old equipment by a new one, but is concerned with replacing an existing process in a system with another process which makes the entire system more effective. We discuss below some of the relevant factors that affects investment decisions: (i) Management Outlook: lf the management is progressive and has an aggressively marketing and growth outlook, it will encourage innovation and favor capital proposals which ensure better productivity on quality or both. In some industries where the product being manufactured is a simple standardized one, innovation is difficult and management would be extremely cost conscious. In contrast, in industries such

as chemicals and electronics, a firm cannot survive, if it follows a policy of 'make-do' with its existing equipment. The management has to be progressive and innovation must be encouraged in such cases. (ii) Competitors Strategy: Competitors' strategy regarding capital investment exerts significant influence on the investment decision of a company. If competitors continue to install more equipment and succeed in turning out better products, the existence of the company not following suit would be seriously threatened. This reaction to a rival's policy regarding capital investment often forces decision on a company' (iii) Opportunities created by technological change: Technological changes create new equipment which may represent a major change in process, so that there emerges the need for re-evaluation of existing capital equipment in a company. Some changes may justify new investments. Sometimes the old equipment which has to be replaced by new equipment as a result of technical innovation may be downgraded to some other applications, A proper evaluation of this aspect is necessary, but is often not given due consideration. In this connection, we may note that the cost of new equipment is a major factor in investment decisions. However the management should think in terms of incremental cost, not the full accounting cost of the new equipment because cost of new equipment is partly offset by the salvage value of the replaced equipment. In such analysis an index called the disposal ratio becomes relevant. Disposal ratio = (Salvage value, Alternative use value) / Installed cost

(iv) Market forecast: Both short and long run market forecasts are influential factors in capital investment decisions. In order to participate in long-run forecast for market potential critical decisions on capital investment have to be taken. (v) Fiscal Incentives: Tax concessions either on new investment incomes or investment allowance allowed on new investment decisions, the method for allowing depreciation deduction allowance also influence new investment decisions. (vi) Cash flow Budget: The analysis of cash-flow budget which shows the flow of funds into and out of the company may affect capital investment decision in two ways. 'First, the analysis may indicate that a company may acquire necessary cash to purchase the equipment not immediately but after say, one year, or it may show that the purchase of capital assets now may generate the demand for major capital additions after two years and such expenditure might clash with anticipated other expenditures which cannot be postponed. Secondly, the cash flow budget shows the timing of cash flows for alternative investments and thus helps management in selecting the desired investment project. (vii) Non-economic factors: new equipment may make the workshop a pleasant place and permit more socializing on the job. The effect would be reduced absenteeism and increased productivity. It may be difficult to evaluate the benefits in monetary terms and as such we call this as non-economic factor. Let us take one more example. Suppose the installation of a new

machine ensures greater safety in operation. It is difficult to measure the resulting monetary saving through avoidance of an unknown number of injuries. Even then, these factors give tangible results and do influence investment decisions