An efficient allocation of capital is the most important finance function in the modern items. It involves decisions to commit the firm's 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 firm's 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 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 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 firm's 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.
Importance of Investment Decisions
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
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 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.
A long-term commitment of funds may also change the risk complexity of the firm. If the adoption of an 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.
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 externally.
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.
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.