Types of Capital Investment Decisions

A capital investment may be defined as an investment which yields returns during several future time periods, and may be contrasted with other types of investments which yield all their return in the current time period. Capital investment decisions may concern the following:

(a) the acquisition or replacement of long-lived assets, such as buildings and plant;

(b) the investment of funds into another firm from which revenues will flow;

(c) a special project which will affect the firm's future earning capacity, such as a research project or an advertising campaign;

(d) the extension of the range of activities of the firm involving a capital outlay, such as a new production line or indeed a new product.

Capital investment decisions encompass two aspects of long-range profitability: first, estimating the future net increases in cash inflows or net savings in cash outlays which will result from the investment; and second, calculating the total cash outlays required to effect the investment.

The analysis of capital investment proposals

In the analysis of capital investment proposals, many of the important facts are uncertain, so that the first problem is to reduce the area of uncertainty before a decision is made. As we shall see, risk analysis offers methods for handling the problem of uncertainty. The second problem is to ensure that all known facts are correctly assessed and quantified. Both known and uncertain facts are estimated in cash terms, and the methods of capital investment appraisal focus on cash flows.

The selection of investment projects is always a question of considering which of several competing alternatives is the best from the firm's point of view. By quantifying the cash inflows and the cash outlays which are involved in the various alternatives, a decision may be made by selecting that alternative which is preferred by the firm.

Example

Wall Street Finance Ltd is offered the opportunity of selecting two investments, each of which will yield £500,000 yearly. Investment A requires a total cash outlay of £5,000,000-hence it promises a rate of return of 10 per cent. Investment B requires a total cash outlay of £50,000,000-and therefore offers a rate of return of 1 per cent per annum. The firm would prefer investment A. However, if the firm has a minimum acceptable rate of return of 15 per cent, neither project would be acceptable.

We may conclude, therefore, that there are three major factors affecting capital investment decisions:

(a) The net amount of the investment required, expressed as the total cash outlay needed to support the project during its entire life.

(b) The net returns on the investment, expressed as the future expected net cash inflows. These may be actual cash flows, or cash savings.

(c) The rate of return on investment, expressed as a percentage. The determination of the lowest acceptable rate of return on investment will be influenced by a number of factors, among which are the firm's rate of return on its other investment opportunities and the cost of capital to the firm.


Interested in Cash Flow Statements?

Read on: Planning Capital Expenditure

The level of a firm's profits depends upon the success with which it is able to employ all its assets-human and non-human. The firm's future profitability depends on two factors, firstly, maintaining and enlarging its asset structure, and secondly, devising a successful strategy for that asset structure. The previous webpage drew attention to the fact that preparing the capital expenditure plan is part of the long-range planning process. The activity of investing in new assets, often termed capital budgeting, involves planning capital expenditure and arranging the financing of this expenditure. It... see: Planning Capital Expenditure