Importance of Capital Investment Decisions

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.

  1. 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.
  2. 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.
  3. 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.
  4. 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.

Importance of Capital Investment Decisions

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.

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