Capital Investment Decisions

"Capital Investment Decisions"Capital investment is defined as the acquisition of a fixed asset that is anticipated to have a long life of use before it has to be replaced or repaired. Capital investment is the money invested in a business venture with an expectation of income, and recovered through earnings generated by the business over several years. It is the capital expenditure than for day-to-day operations or the working capital or other expenses.

The capital investment decisions are mainly governed by the process of ranking and identifying the capital investments of the firm. The firm needs to decide which of the given investments will ensure the most value to the business.

Nature or Characteristics of Capital Investment Decisions:

The characteristic of a capital investment decision is an investment of long-term choices about which projects receive investment, whether to finance that investment with equity or debt, and when or whether to pay dividends to shareholders. On the other hand, a short-term decision deal with the short-term balance of current assets and current liabilities; the focus here is on managing cash, inventories, and short-term borrowing and lending (such as the terms on credit extended to customers)

Capital investment decision-making is important to a business because these expenditures also have the following characteristics:

  • They usually involve large sums of money relative to the size of the business operation. The purchase of a delivery vehicle for a small business may be a large outlay but the acquisition of one delivery vehicle for a supermarket chain would not be that significant. However, if the supermarket chain were to replace all its delivery vehicles at one time then it would be a large outlay. Due to the large cost of the investment, businesses will often have to raise finance in addition to their own funds.
  • The expenditures are usually for the long term. The acquisition of non-current assets means that the impact of the decision will be felt by the business for a long period of time. There is an expectation that the assets will generate cash flow and profit over time and that they will be sufficient to repay the debt finance, if required, also over a long period of time.
  • The decision cannot be easily reversed. The decisions are difficult to change as the outlay has been made and to make any change would be costly to the business. For example, if, one year after the purchase of a particular type of delivery vehicle, the decision turns out to be the wrong one because a more advanced vehicle is now on the market, the cost of selling the now unsuitable vehicle will involve a considerable loss because of its substantially reduced market value.
  • They have a high risk attached to them. The combination of the three previous characteristics mentioned above means that the assets must generate cash flow and profits well into the future so that lenders can be repaid and investors receive a reward. The long term is uncertain as it can be difficult to predict, for example:
  1. the rate of technological change
  2. economic circumstances
  3. customer preferences
  4. what your competitors will do.

Importance of Capital Investment Decisions:

The following motives will clearly explain why capital budgeting is very important for a firm: 1. Expansion: Capital budgeting is directed towards expansion of the level of operations. It is done through acquisition of fixed assets by purchasing property and plant facilities, which in turn ensure a proper investment and balancing in investment. 2. Replacement: After maturity period when firm’s growth slows down, it is required to replace or renew some outdated or worn-out assets, i.e. machinery, equipment, vehicles, etc. Thus a firm can return into its full-fledged production and generate desired benefits. 3. Renewal: As an alternative to replacement, renewal may involve rebuilding, overhauling or retrofitting an existing asset. It certainly increases the productions and profits of a firm. 4. Other importance: There are certain other importance’s of capital expenditure, which include – a) Plan for securing funds b) Retain a competitive position in the market c) Sales and cash forecast d) Sales guarantee e) Comparative study of alternative projects and launching new products f) Outlays for advertising, research and development, management consulting, etc.

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