Investment decision otherwise known as capital budgeting decision is perhaps the most important decision taken by a Finance Manager. Whatever is the objective of the firm, whether profit maximization or wealth maximization, capital budgeting decision affects performance of the firm decisively. These investment decisions have the following implications for the firm.
- They define the strategic focus and direction of the business. The capital expenditure made in new investments may result in entry into new products, services or new markets.
- Capital budgeting decisions require large funds and generally have long repayment periods. The results of capital budgeting continue to impact the finances of the firm for many years. Due to long project life, assessment involves number of years of future events leading to difficulty and uncertainty regarding the accuracy of assessment.
- Capital budgeting decisions are mostly irreversible. They involve investment in plant and machinery or new soft wares or technology etc. They are normally industry or user specific. If the project does not proceed ahead, it may be difficult to find buyers for the assets and the only alternative would be scar the assets at a huge loss.
- An under investment will result in inefficient operations like inadequate capacity and, increased expenditure, non competitive production and pricing resulting in poor market share and have serious financial implications. On the other hand an over investment would result in higher depreciation and increased operating costs and result in liquidity crisis.
Therefore Finance Managers carefully align capital investments with the short term and long-term company goals, analyze impact of such investments over a period of time and scrutinize capital budgeting decisions both technically and financially. While the capital investment decisions of the firm are very important, Finance Managers face certain difficulties in fully appraising the decisions. These difficulties are inevitable and are due to the very nature of the investment, which relies on future events for achieving the objects of the investment. The major difficulties are
- Measurement of the costs and benefits: Measuring the costs and benefits of the proposal is difficult particularly when involves intangibles like benefits of employment, improvement in quality of life etc.
- Uncertainty associated with future: The precise value of cost and benefit is difficult to quantify as benefits are spread over a period in future which is characterized by uncertainty.
- Difficulty of comparison: As the costs and benefits of an investment proposal is spread over period of time occurring at different points of time, comparing the values on a commons basis is difficult due to the changes in value of money over a time horizon.