Capital Investment Decisions: Meaning, Significance and Techniques

After reading this article you will learn about:- 1. Meaning of Capital Investment Decisions 2. Significance of Capital Investment Decisions 3. Techniques used.

Meaning of Capital Investment Decisions:

Investment means laying out the money (also known as outlay) on an activity or a project with the expectation of some benefit.

In an enterprise, expenditure may be either:

(a) To carry out normal operational transactions or

(b) To plan for the acquisition of assets which will in­crease production and wealth.

Former is generally termed as ‘current’ expenditure, and is ex­pected to result in benefits in a short period of less than a year. The latter is termed as ‘capital’ expenditure, and is expected to result in benefits in future period of one or more years and is also known as capital budgeting decisions.

An investment proposal should be judged in relation to whether or not it provides a return equal to, or greater than, that required by investors. Capital budgeting is involved in generat­ing investment proposals consistent with the firm’s strategic objectives.

Capital budgeting can be defined as the process of identifying, analysing, and selecting investment projects whose returns are expected to extend beyond one year.

Capital expenditure proposals include:

i. Purchase of equipment, land or building in order to expand or to diversify into a new line of business.

ii. Replacement of an existing capital asset.

iii. Expenditure on research and development programme.

iv. Lease or buy analysis.

Capital expenditure proposals may be aimed at:

(a) Acquisition of a new plant to increase the production capacity, or to improve the prod­uct through adopting changed technology.

(b) Minimizing the cost of production arising due to a decision relating to the choice of production processes, and plant replacement decisions.

(c) Non-economic developments like pollution control, fire protection etc.

It is difficult to estimate future benefits accurately from new investment due to uncertainty and risk. Therefore investment proposals should be evaluated in terms of both expected return and risk. This requires a careful assessment of alternative proposals so as to ensure safety, profitability and liquidity of the enterprise.

For making investment acceptable practice is to prepare a comparative statement of cur­rent rate of interest and profit. The profit in any case should be higher than current rate of interest. This is because if we take capital/money for investment on loan, we are required to pay interest on in it. Therefore, the yield should be greater than the rate of interest so that enter­prise could expect profit.

Significance of Capital Investment Decisions:

Capital investment decisions are basically the examination as to how well the expected future returns justify the related present investments.

Capital investment decisions are highly significant due to number of reasons, some of them are:

(a) Investment Linked with Objectives:

An enterprise with an objective of survival and growth, incurs capital expenditure every year and takes investment decisions e.g., investment in fixed assets and inventory.

(b) Long Term Commitments:

A capital project, like hydroelectric project is expected to bring benefits in future years. Such projects require the commitment of funds for future years, and draw the future direction by determining its product, markets, production facilities and technology.

(c) No-Going Back:

It is difficult to reverse a capital project decision.

Techniques used in Capital Investment Decisions:

For taking capital investment decisions, following techniques are used to evaluate and se­lect the alternative methods:

1. Payback Period:

This technique determines as to how long it will take (in years) to payback invested capital.

This period can be determined using the following formula:

P = C/R

where, P = Pay-back period in year

C = Original capital investment

R = Annual return expected i.e., total annual earnings after deducting taxes.

This method is not much reliable as it does not take into account its insurance, interest and maintenance. Further, in the beginning, the return is generally less, which increases gradually, but here we consider it as constant. This method also does not consider depreciation and obso­lescence.

2. Present Worth Method:

This method is more accurate and reasonable and is used to evaluate the present value of new equipment. For the purpose of comparison, future costs are translated into today’s money.

A ‘present-worth rupee’ is today’s value of money invested (at certain interest rate) after given number of years from today.

This can be clearly understood by the following example:

If we have Rs.5000 to invest and want to know what will be its worth in ten years at 10 percent interest, using the formula

F = P (1 + i)ⁿ

where, F = Worth of money in future

P = Present amount of money

i = Interest rate

n = Number of years.

Substituting in this formula, we have

F = 5000 (1 + 0.10)¹⁰ = 5000 (2.594) = Rs.12,970

Thus, Rs.5,000 today is worth Rs.12,970 after ten years from now or in other words Rs.12,970 after ten years from now has a present worth of Rs.5,000.

While comparing two alternatives, all the costs must be translated into present-worth and they must be compared for equal length of services, e.g., if machine A has its life of 3 years and B has 6 years, then to compare two machines, we must compare the present worth value of 6 years’ service of two A machines and one B machine.

3. Rate of Return Method:

In this method, average annual net income (after tax and depreciation deductions) is expressed as percentage of capital investment.

The formula used for this purpose is:

Percentage rate of return = Earning per year/Net investment x 100}>

Discounted Rate of Return:

In this case, following formula is used:

C = R / (1+r)ⁿ

where, C = Investment cost

R – Expected earning in nth year

r = Rate of return.

If we have to find out the rate of return when a machine has worked for n years and earn­ings in each year is R₁ (in first year), R₂ (in second year), R₃ (in third year) and so on, then following formula is used for calculating r, by trial and error method:

C = R₁/(1 + r) + R₂/(1 + r)² + R₃/(1 + r)³ + … R_n/(1 + r)ⁿ + S/(1 + r)ⁿ

S = Salvage value of machine after n years.

4. MAPI Method:

The term MAPI stands for Machinery and Allied Products Institute of Washington, which has developed this method. This is a new method and was developed by George Teborgh, the director of this institute.

The reasoning behind this method is described as follows:

Almost all the equipment’s are subjected to deterioration and obsolescence in varying degree with the passage of time. Thus with the passage of time, operating inferiority increases. Hence the old machine has this operating inferiority high and book value as low.

While a new machine to be purchased will have operating inferiority minimum and cost as a maximum. Hence the problem before manager is to choose between more capital cost and less imperfection on one hand and less capital cost and more imperfection on the other.

The MAPI has developed a new approach which helps in deciding this problem. The exist­ing equipment which is to be replaced is known as Defender and the new which will replace the old one is known as the Challenger.

For estimating as to whether the proposed replacement is profitable, the adverse ‘mini­mum’ of the defender and the challenger are found and compared. ‘Adverse minimum’ of the defender or the challenger is the lowest sum of the time adjusted average of capital cost and operating inferiority (expressed in terms of money) obtainable from a machine. The calculations can easily be done with the help of MAPI charts.