Meaning of Investment Decisions: Financial Management

Investment can be defined as the acquisition of an asset to create wealth using a specific source of income. For instance, a company can use its debt and/or equity capital to purchase an asset such as stock, bonds, or property for the purpose of earning interest or profits. An investment is a process of gaining profit by acquiring and using an asset for a specific period of time.

The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions. A capital budgeting decision may be defined as the firm’s decision to invest its current funds most efficiently in the long-term assets in anticipation of an expected flow of benefits over a series of years. Long-term assets are those that affect the firm’s operations beyond the one-year period. Acquisition of short term assets such as stock which last for less than 1 year is not considered as an investment.

The firm’s investment decisions would generally include expansion, acquisition, modernization and replacement of the long-term assets. Sale of a division or business (divestment) is also as an investment decision. Decisions like the change in the methods of sales distribution, or an advertisement campaign or a research and development programme have long-term implications for the firm’s expenditures and benefits, and therefore, they should also be evaluated as investment decisions.

The key features of investment decisions are:

  • The exchange of current funds for future benefits.
  • The funds are invested in long-term assets.
  • The future benefits will occur to the firm over a series of years.

It is significant to emphasize those expenditures and benefits of an investment should be measured in cash. In the investment analysis, it is cash flow, which is important, not the accounting profit. It may also be pointed out that investment decisions affect the firm’s value. The firm’s value will increase if investments are profitable and add to the shareholders’ wealth. Thus, investments should be evaluated on the basis of a criterion, which is compatible with the objective of the shareholders’ wealth maximization. An investment will add to the shareholders’ wealth if it yields benefits in excess of the minimum benefits as per the opportunity cost of capital. In this unit, we assume that the investment project’s opportunity cost of capital is known. We also assume that the expenditures and benefits of the investment are known with certainty.

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