Nature, Importance and types of investment decisions 


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Nature

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 in anticipation of an expected flow of benefits over a series of years. The long-term assets are those that affect the firm’s operation beyond the one-year period. The firm’s investment decisions would generally include expansion; acquisition decisions would generally include expansion, acquisition, modernization and replacement of the long-term assets. Sale of a division or business (divestment) is also as an investment decision. Decisions like the change in the methods of sales distribution, or an advertisement campaign or a research and capital. In this chapter, we assume that the investment project’s opportunity cost of capital is known. We also assume that the expenditure and benefits of the investment are known with certainty.

Investment Importance

Investment decisions require special attention because of the following reasons:

• They influence the firm’s growth in the long run
• They affect the risk of the firm
• They involve commitment of large amount of funds
• They are irreversible, or reversible at substantial loss
• They are among the most difficult decisions to make.

Growth

The effects of investment decisions extend into the future and have to be endured for a longer period than the consequences of the current operating expenditure. A firm’s decision to invest in long-term assets has a decisive influence decision to invest in long-term assets has a decisive influence on the rate and direction of its growth. A wrong decision can prove disastrous for the continued survival of the firm; unwanted or unprofitable expansion of assets will result in heavy operating costs to the firm. On the other hand, inadequate investment in assets would make it difficult for the firm to compete successfully and maintain its market share.

Risk

A long-term commitment of funds may also change the risk complexity of the firm, if the adoption of am investment increases average gain but causes frequent fluctuations in its earnings, the firm will become more risky. Thus, investment decisions shape the basic character of a firm.

Funding

Investment decisions generally involve large amount of funds, which make it imperative for the firm to plan its investment programmers very carefully and make an advance arrangement for procuring finances internally or extremely.

Irreversibility

Most investment decisions are irreversible. It is difficult to find a market for such capital items once they have been acquired. The firm will incur heavy losses if such assets are scrapped.

Complexity

Investment decisions are among the firm’s most difficult decisions. They are an assessment of future events, which are difficult to predict. It is really a complex problem to correctly estimate the future cash flows of an investment economic, political, social and technological forces cause the uncertainty in cash flow estimation.

Investment Decisions Types

There are many ways to classify investment. One classification is as follows:

• Expansion of existing business
• Expansion of new business
• Replacement and modernization.
Expansion and diversification

A company may add capacity to its existing product lines to expand existing operations. For example, the Gujarat state fertilizer company (GSFC) may increase its plant capacity to manufacture more urea. 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 packaging manufacturing company invests in a new plant and machinery to produce ball bearing, which the firm has not manufactured 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. Investments in existing or new products may also be called as revenue-expansion investments.

Replacement and modernization

The main adjective of modernization and replacement is to improve operating efficiency and reduce costs, cost savings will reflect in the increased profits, but the firm’s revenues 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 cement company changes from semi-automatic drying equipment to fully automatic drying 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 improvement expand revenues as well as reduce costs.