Investment Decisions: Meaning, Need and Factors Affecting It

In this article we will discuss about:- 1. Meaning of Investment Decisions 2. Categories of Investment Decisions 3. Need 4. Factors.

Meaning of Investment Decisions:

In the terminology of financial management, the investment decision means capital budgeting. Investment decision and capital budgeting are not considered different acts in business world. In investment decision, the word ‘Capital’ is exclusively understood to refer to real assets which may assume any shape viz. building, plant and machinery, raw material and so on and so forth, whereas investment refers to any such real assets.

In other words, investment decisions are concerned with the question whether adding to capital assets today will increase the revenues of tomorrow to cover costs. Thus investment decisions are commitment of money resources at different time in expectation of economic returns in future dates.

Choice is required to be made amongst available alternative revenues for investments. As such investment decisions are concerned with the choice of acquiring real assets over the time period in a productive process.

Categories of Investment Decisions:

There are several categories of investment decisions.

The common categories are as follows:

(i) Inventory Investment:

Holding of stocks of materials is unavoidable for smooth running of a business. The expenditure on stocks comes in the category of investments.

(ii) Strategic Investment Expenditure:

In this case, the firm makes investment decisions in order to strengthen its market power. The return on such investment will not be immediate.

(iii) Modernisation Investment Expenditure:

In this case, the firm decides to adopt a new and better technology in place of the old one for the sake of cost reduction. It is also known as capital deepening process.

(iv) Expansion Investment on a New Business:

In this case, the firm decides to start a new business or diversify into new lines of production for which a new set of machines are to be purchased.

(v) Replacement Investment:

In this category, the firm takes decisions about the replacement of worn out and obsolete assets by new ones.

(vi) Expansion Investment:

In this case, the firm decides to expand the productive capacity for existing products and thus grows further in a uni-direction. This type of investment is also called capital widening.

Need for Investment Decisions:

The need for investment decisions arrives for attaining the long term objective of the firm viz. survival or growth, preserving share of a particular market and retain leadership in a particular aspect of economic activity.

The firm may like to make investment decision to avail of the economic opportuni­ties which may arise due to the following reasons:

(i) Expansion of the productive process to meet the existing excessive demand in local market to exploit the international markets and to avail the benefits of economies of scale.

(ii) Replacement of an existing asset, plant, machinery or building may become necessary for reaping advantages of technological innovations, minimising cost of products and increasing the effi­ciency of labour.

(iii) Buy or hire on rent or lease a particular asset is another important consideration which establishes the need for making investment decisions.

Factors affecting Investment Decisions:

According to Prof. Ezra Solomon, for making optimum investment decisions, the following three types of information is required:

(i) Estimate of capital outlays and the future earnings of the proposed project focusing on the task of value engineering and market forecasting,

(ii) Availability of capital and consideration of cost-focusing attention as financial analysis, and

(iii) A correct set of standards by which to select projects for execution to maximise return-focusing attention on logic and arithmetic.

1. Estimate of Capital Outlays and Future Earnings of the Proposed Project:

The management of a firm is guided by various considerations in forecasting the future revenue proceeds arising out of present investment decisions. In current managerial practice if the time horizon over which benefits accrue is longer than one year, then the resources committed are called investment and the money spent is termed capital expenditures. The fixed capital outlay shows the outlay or expenditure made by the firm for creating the capacity of production.

The important times of such costs would be as follows:

(i) Advance Expenditure:

The expenditure on technical and economic feasibility reports, plant design, licence fee and associated costs, expenditure on the search for finances, and other similar items would be included in this category.

(ii) Land and Site Development Expenditure:

This includes the cost of land acquired or leasing of land, expenditures on making the land usable, laying of roads, fencing, etc.

(iii) Construction Costs:

The expenditures on factory buildings, residential houses, roads, electricity supply lines, drainage disposal system, water supply, etc.

(iv) Machines and Tools:

The cost of machinery should include purchase price of machines, duty, tax, freight insurance, transport charges, etc. Different types of tools will be required for opera­tion, the value of such sets at the plant will be the cost of tools.

(v) Erection of Equipment:

The whole plant constituting different types of machines has to be assembled at the plant site. The payment made for installation will be accounted in this category.

(vi) Training Expenditure:

A firm before purchasing such machines has to get its personnel trained to handle them. The cost incurred on such training will have to be accounted.

(vii) Franchise Cost:

The cost incurred in getting the franchise from the government or any other institution is also included in this category.

(viii) Cost of Mobilising Finance:

The firms raise funds partly in the form of shares, bonds, debentures and fixed deposit from the public at large. A well-diversified portfolio carefully chosen from the numerous securities available in the market will help the investor in achieving his objectives.

(ix) Inventory Cost:

The decision to hold inventories to meet demand is quite important for a firm and in certain situations the level of inventories serves as a guide to plan production. The value of such safety inventories would be included in the establishment cost.

The above costs are concerned with the establishment of a plant. If the plant is ready for operation, it requires certain amount of money to meet the operating costs.

The broad categories of such costs are as follows:

(i) Labour cost,

(ii) Repairing charges and maintenance cost,

(iii) Rent and royalty payments,

(iv) Insurance charges,

(v) Stationery cost,

(vi) Payment of tax and duties, and

(vii) Fuel and power costs.

In addition to the above categories of costs, two other categories of annual costs are the depre­ciation provision and interest charges. The investment decisions are directly related to financing deci­sions. The acceptance of investment proposal shall depend upon how they are going to be financed.

2. Sources of Capital:

Sources of capital can be divided into the following four categories:

(i) Internal Capital:

It is generated by the firm itself. It includes retained profit, depreciation provision, taxation provision and other reserves.

(ii) Short-term Capital:

It is needed to meet day to day expenses (working capital).

(iii) Medium-term Capital:

It may be sought for investment in plant and equipment or semi­-permanent or permanent addition to current assets. It can be of any use between one to ten years.

(iv) Long-term Capital:

It is needed to meet the requirements of fixed capital formation.

Cost of Capital:

The cost of capital plays a very important role in appraising investment decisions. Whenever a firm mobilises capital from different sources, it has to consider the cost of capital very carefully for making the final choice.

Interest can be explained as an amount which is paid by a borrower for using funds belonging to some- one else. Therefore, it is a transaction between surplus and deficit units.

The investor should know that he has to cope with the different kinds of interest rates called by different names and to be a successful investor, he should be able to recognise the kinds of interest rates and by whom these rates are fixed. The investor should also carefully analyse the different kinds of interest rates available in the economy before he makes his investments.

Different kinds of interest rates existing in the markets are listed below:

(i) Ceiling Rate of Interest:

It is the maximum rate of interest usually fixed by the Govern­ment of India and the RBI. It depends on the face value of a financial instrument.

(ii) Coupon Rate of Interest:

It is the rate of interest which is paid on the face value of a bond or debenture. A person who purchases a long-term bond or debenture expects an interest in the form of coupon.

(iii) Market Rate of Interest:

It indicates the present value of the future cash flows which is generated by an investment with the cost incurred on making such investment.

(iv) Long-term Interest:

It comprises of a period usually above five years or above ten years.

(v) Medium-term Interest:

It may vary from a period of one year to five years.

(vi) Short-term Interest:

It varies per day, per week, per month, per year and the maximum number of years for which it may be considered can be of one year.

Methods for Calculating Cost of Capital:

The rate of interest is an indication of the real productivity of capital goods.

The different methods for calculating cost of capital for each source of financing investment decisions are as follows:

(i) Cost of Debt:

The cost of debt (Cd) is the contracted rate of interest payable on the borrowed capital after adjusting tax liability of the company.

Cd = (1-T_R) R₁

Where Cd = Cost of debt capital

T_R = Marginal tax rate

R₁ = Contracted rate of interest

(ii) Cost of Equity Capital:

It is the minimum return which investors wish to get on their equity stocks.

C_e = D₁ + G_R/P₀

Where C_e = Cost of equity capital.

D₁ = Dividend paid in period 1

P₀ = Market value of the share

G_r = Growth rate of dividends

(iii) Cost of Preference Capital:

Preferred stock has an investment value.

The cost of preference share may be calculated as:

C_P = D/R

Where C_p = Cost of preference capital

D = fixed amount of dividend obligation owned by the firm.

R = Net returns received as sale of preference stock.

(iv) Cost of Term Loans:

The term loan is generally repayable in more than one year and less than ten years. The cost of the term loan is equal to the interest rate multiplied by (1-tax rate). The interest rate refers to the interest rate of the new term loan.

(v) Cost of Retained Earnings:

The cost of retained earnings is generally taken to be the same as the cost of equity.

The formula for cost of retained earnings in this case is as follows:

C_R = D(1 – T₁)/P(1 – T_C)

Where C_R = Cost of retained earnings

D = Dividend per share

T₁ = Marginal Income Tax

P = Market price per share

T_c = Capital gains tax.

3. Selection of Projects to Maximise Returns:

For successful operation of any business, it is imperative that such investment of funds should be made so as to bring in benefits or best possible returns or maximum returns. A most decisive factor in taking decision on investment expenditure is its profitability.