Investment Decisions- 1 | Financial Management & Economics Finance: CA Intermediate (Old Scheme) PDF Download

 Page 1


 
LEARNING OUTCOMES 
 
 
  
 INVESTMENT DECISIONS  
 
 
? State the objectives of capital investment decisions. 
? Discuss the importance and purpose of Capital budgeting for 
a business entity. 
? Calculate cash flows in capital budgeting decisions and try to 
explain the basic principles for measuring the same. 
? Discuss the various investment evaluation techniques like 
Pay-back, Net Present Value (NPV), Profitability Index (PI), 
Internal Rate of Return (IRR), Modified Internal Rate of Return 
(MIRR) and Accounting Rate of Return (ARR). 
? Apply the concepts of the various investment evaluation 
techniques for capital investment decision making. 
? Discuss the advantages and disadvantages of the above-
mentioned techniques. 
CHAPTER 
7 
Page 2


 
LEARNING OUTCOMES 
 
 
  
 INVESTMENT DECISIONS  
 
 
? State the objectives of capital investment decisions. 
? Discuss the importance and purpose of Capital budgeting for 
a business entity. 
? Calculate cash flows in capital budgeting decisions and try to 
explain the basic principles for measuring the same. 
? Discuss the various investment evaluation techniques like 
Pay-back, Net Present Value (NPV), Profitability Index (PI), 
Internal Rate of Return (IRR), Modified Internal Rate of Return 
(MIRR) and Accounting Rate of Return (ARR). 
? Apply the concepts of the various investment evaluation 
techniques for capital investment decision making. 
? Discuss the advantages and disadvantages of the above-
mentioned techniques. 
CHAPTER 
7 
 
 
7.2 FINANCIAL MANAGEMENT  
 7.1 INTRODUCTION 
In the first chapter we have discussed the three important functions of financial 
management which were Investment Decisions, Financing Decisions and Dividend 
Decisions. So far, we have studied Financing decisions in previous chapters. In this 
chapter we will discuss the second important decision area of financial 
management which is Investment Decision. Investment decision is concerned with 
optimum utilization of fund to maximize the wealth of the organization and in turn 
the wealth of its shareholders. Investment decision is very crucial for an 
organization to fulfil its objectives; in fact, it generates revenue and ensures long 
term existence of the organization. Even the entities which exist not for profit are 
also required to make investment decision though not to earn profit but to fulfil its 
mission.  
As we have seen in the financing decision chapter each rupee of capital raised by 
an entity bears some cost, commonly known as cost of capital. It is necessary that 
each rupee raised is to be invested in a very prudent manner. It requires a proper 
planning for capital, and it is done through a proper budgeting. A proper budgeting 
 7
 
Page 3


 
LEARNING OUTCOMES 
 
 
  
 INVESTMENT DECISIONS  
 
 
? State the objectives of capital investment decisions. 
? Discuss the importance and purpose of Capital budgeting for 
a business entity. 
? Calculate cash flows in capital budgeting decisions and try to 
explain the basic principles for measuring the same. 
? Discuss the various investment evaluation techniques like 
Pay-back, Net Present Value (NPV), Profitability Index (PI), 
Internal Rate of Return (IRR), Modified Internal Rate of Return 
(MIRR) and Accounting Rate of Return (ARR). 
? Apply the concepts of the various investment evaluation 
techniques for capital investment decision making. 
? Discuss the advantages and disadvantages of the above-
mentioned techniques. 
CHAPTER 
7 
 
 
7.2 FINANCIAL MANAGEMENT  
 7.1 INTRODUCTION 
In the first chapter we have discussed the three important functions of financial 
management which were Investment Decisions, Financing Decisions and Dividend 
Decisions. So far, we have studied Financing decisions in previous chapters. In this 
chapter we will discuss the second important decision area of financial 
management which is Investment Decision. Investment decision is concerned with 
optimum utilization of fund to maximize the wealth of the organization and in turn 
the wealth of its shareholders. Investment decision is very crucial for an 
organization to fulfil its objectives; in fact, it generates revenue and ensures long 
term existence of the organization. Even the entities which exist not for profit are 
also required to make investment decision though not to earn profit but to fulfil its 
mission.  
As we have seen in the financing decision chapter each rupee of capital raised by 
an entity bears some cost, commonly known as cost of capital. It is necessary that 
each rupee raised is to be invested in a very prudent manner. It requires a proper 
planning for capital, and it is done through a proper budgeting. A proper budgeting 
 7
 
7.3 
INVESTMENT DECISIONS 
requires all the characteristics of budget. Due to this feature, investment decisions 
are very popularly known as Capital Budgeting, which means applying the 
principles of budgeting for capital investment.   
In simple terms, Capital Budgeting involves: - 
? Identification of investment projects that are strategic to business’ overall 
objectives; 
? Estimating and evaluating post-tax incremental cash flows for each of the 
investment proposals; and 
? Selection of an investment proposal that maximizes the return to the 
investors. 
 7.2 PURPOSE OF CAPITAL BUDGTETING 
The capital budgeting decisions are important, crucial and critical business 
decisions due to following reasons: 
(i) Substantial expenditure: Investment decisions are related with fulfillment of 
long term objectives and existence of an organization. To invest in a project or 
projects, a substantial capital investment is required. Based on size of capital and 
timing of cash flows, sources of finance are selected. Due to huge capital 
investments and associated costs, it is therefore necessary for an entity to make 
such decisions after a thorough study and planning.  
(ii) Long time period: The capital budgeting decision has its effect over a long 
period of time. These decisions not only affect the future benefits and costs of 
the firm but also influence the rate and direction of growth of the firm. 
(iii) Irreversibility: Most of the investment decisions are irreversible. Once the 
decision implemented it is very difficult and reasonably and economically not 
possible to reverse the decision. The reason may be upfront payment of amount, 
contractual obligations, technological impossibilities etc. 
(iv) Complex decisions: The capital investment decision involves an assessment of 
future events, which in fact is difficult to predict. Further it is quite difficult to 
estimate in quantitative terms all the benefits or the costs relating to a particular 
investment decision. 
 
Page 4


 
LEARNING OUTCOMES 
 
 
  
 INVESTMENT DECISIONS  
 
 
? State the objectives of capital investment decisions. 
? Discuss the importance and purpose of Capital budgeting for 
a business entity. 
? Calculate cash flows in capital budgeting decisions and try to 
explain the basic principles for measuring the same. 
? Discuss the various investment evaluation techniques like 
Pay-back, Net Present Value (NPV), Profitability Index (PI), 
Internal Rate of Return (IRR), Modified Internal Rate of Return 
(MIRR) and Accounting Rate of Return (ARR). 
? Apply the concepts of the various investment evaluation 
techniques for capital investment decision making. 
? Discuss the advantages and disadvantages of the above-
mentioned techniques. 
CHAPTER 
7 
 
 
7.2 FINANCIAL MANAGEMENT  
 7.1 INTRODUCTION 
In the first chapter we have discussed the three important functions of financial 
management which were Investment Decisions, Financing Decisions and Dividend 
Decisions. So far, we have studied Financing decisions in previous chapters. In this 
chapter we will discuss the second important decision area of financial 
management which is Investment Decision. Investment decision is concerned with 
optimum utilization of fund to maximize the wealth of the organization and in turn 
the wealth of its shareholders. Investment decision is very crucial for an 
organization to fulfil its objectives; in fact, it generates revenue and ensures long 
term existence of the organization. Even the entities which exist not for profit are 
also required to make investment decision though not to earn profit but to fulfil its 
mission.  
As we have seen in the financing decision chapter each rupee of capital raised by 
an entity bears some cost, commonly known as cost of capital. It is necessary that 
each rupee raised is to be invested in a very prudent manner. It requires a proper 
planning for capital, and it is done through a proper budgeting. A proper budgeting 
 7
 
7.3 
INVESTMENT DECISIONS 
requires all the characteristics of budget. Due to this feature, investment decisions 
are very popularly known as Capital Budgeting, which means applying the 
principles of budgeting for capital investment.   
In simple terms, Capital Budgeting involves: - 
? Identification of investment projects that are strategic to business’ overall 
objectives; 
? Estimating and evaluating post-tax incremental cash flows for each of the 
investment proposals; and 
? Selection of an investment proposal that maximizes the return to the 
investors. 
 7.2 PURPOSE OF CAPITAL BUDGTETING 
The capital budgeting decisions are important, crucial and critical business 
decisions due to following reasons: 
(i) Substantial expenditure: Investment decisions are related with fulfillment of 
long term objectives and existence of an organization. To invest in a project or 
projects, a substantial capital investment is required. Based on size of capital and 
timing of cash flows, sources of finance are selected. Due to huge capital 
investments and associated costs, it is therefore necessary for an entity to make 
such decisions after a thorough study and planning.  
(ii) Long time period: The capital budgeting decision has its effect over a long 
period of time. These decisions not only affect the future benefits and costs of 
the firm but also influence the rate and direction of growth of the firm. 
(iii) Irreversibility: Most of the investment decisions are irreversible. Once the 
decision implemented it is very difficult and reasonably and economically not 
possible to reverse the decision. The reason may be upfront payment of amount, 
contractual obligations, technological impossibilities etc. 
(iv) Complex decisions: The capital investment decision involves an assessment of 
future events, which in fact is difficult to predict. Further it is quite difficult to 
estimate in quantitative terms all the benefits or the costs relating to a particular 
investment decision. 
 
 
 
7.4 FINANCIAL MANAGEMENT  
 7.3 CAPITAL BUDGETING PROCESS 
The extent to which the capital budgeting process needs to be formalised and 
systematic procedures established depends on the size of the organisation; number 
of projects to be considered; direct financial benefit of each project considered by 
itself; the composition of the firm's existing assets and management's desire to 
change that composition; timing of expenditures associated with the projects that 
are finally accepted. 
 
(i) Planning: The capital budgeting process begins with the identification of 
potential investment opportunities.  The opportunity then enters the planning 
phase when the potential effect on the firm's fortunes is assessed and the ability 
of the management of the firm to exploit the opportunity is determined.  
Opportunities having little merit are rejected and promising opportunities are 
advanced in the form of a proposal to enter the evaluation phase. 
(ii) Evaluation: This phase involves the determination of proposal and its 
investments, inflows and outflows.  Investment appraisal techniques, ranging 
from the simple payback method and accounting rate of return to the more 
sophisticated discounted cash flow techniques, are used to appraise the 
proposals.  The technique selected should be the one that enables the manager 
to make the best decision in the light of prevailing circumstances. 
(iii) Selection: Considering the returns and risks associated with the individual 
projects as well as the cost of capital to the organisation, the organisation will 
choose among projects so as to maximise shareholders’ wealth. 
(iv) Implementation: When the final selection is made, the firm must acquire the 
necessary funds, purchase the assets, and begin the implementation of the 
project. 
(v) Control: The progress of the project is monitored with the aid of feedback 
reports.  These reports will include capital expenditure progress reports, 
Review Control
Implement
ation
Implement
Selection Selection Evaluation Evaluation Planning
Page 5


 
LEARNING OUTCOMES 
 
 
  
 INVESTMENT DECISIONS  
 
 
? State the objectives of capital investment decisions. 
? Discuss the importance and purpose of Capital budgeting for 
a business entity. 
? Calculate cash flows in capital budgeting decisions and try to 
explain the basic principles for measuring the same. 
? Discuss the various investment evaluation techniques like 
Pay-back, Net Present Value (NPV), Profitability Index (PI), 
Internal Rate of Return (IRR), Modified Internal Rate of Return 
(MIRR) and Accounting Rate of Return (ARR). 
? Apply the concepts of the various investment evaluation 
techniques for capital investment decision making. 
? Discuss the advantages and disadvantages of the above-
mentioned techniques. 
CHAPTER 
7 
 
 
7.2 FINANCIAL MANAGEMENT  
 7.1 INTRODUCTION 
In the first chapter we have discussed the three important functions of financial 
management which were Investment Decisions, Financing Decisions and Dividend 
Decisions. So far, we have studied Financing decisions in previous chapters. In this 
chapter we will discuss the second important decision area of financial 
management which is Investment Decision. Investment decision is concerned with 
optimum utilization of fund to maximize the wealth of the organization and in turn 
the wealth of its shareholders. Investment decision is very crucial for an 
organization to fulfil its objectives; in fact, it generates revenue and ensures long 
term existence of the organization. Even the entities which exist not for profit are 
also required to make investment decision though not to earn profit but to fulfil its 
mission.  
As we have seen in the financing decision chapter each rupee of capital raised by 
an entity bears some cost, commonly known as cost of capital. It is necessary that 
each rupee raised is to be invested in a very prudent manner. It requires a proper 
planning for capital, and it is done through a proper budgeting. A proper budgeting 
 7
 
7.3 
INVESTMENT DECISIONS 
requires all the characteristics of budget. Due to this feature, investment decisions 
are very popularly known as Capital Budgeting, which means applying the 
principles of budgeting for capital investment.   
In simple terms, Capital Budgeting involves: - 
? Identification of investment projects that are strategic to business’ overall 
objectives; 
? Estimating and evaluating post-tax incremental cash flows for each of the 
investment proposals; and 
? Selection of an investment proposal that maximizes the return to the 
investors. 
 7.2 PURPOSE OF CAPITAL BUDGTETING 
The capital budgeting decisions are important, crucial and critical business 
decisions due to following reasons: 
(i) Substantial expenditure: Investment decisions are related with fulfillment of 
long term objectives and existence of an organization. To invest in a project or 
projects, a substantial capital investment is required. Based on size of capital and 
timing of cash flows, sources of finance are selected. Due to huge capital 
investments and associated costs, it is therefore necessary for an entity to make 
such decisions after a thorough study and planning.  
(ii) Long time period: The capital budgeting decision has its effect over a long 
period of time. These decisions not only affect the future benefits and costs of 
the firm but also influence the rate and direction of growth of the firm. 
(iii) Irreversibility: Most of the investment decisions are irreversible. Once the 
decision implemented it is very difficult and reasonably and economically not 
possible to reverse the decision. The reason may be upfront payment of amount, 
contractual obligations, technological impossibilities etc. 
(iv) Complex decisions: The capital investment decision involves an assessment of 
future events, which in fact is difficult to predict. Further it is quite difficult to 
estimate in quantitative terms all the benefits or the costs relating to a particular 
investment decision. 
 
 
 
7.4 FINANCIAL MANAGEMENT  
 7.3 CAPITAL BUDGETING PROCESS 
The extent to which the capital budgeting process needs to be formalised and 
systematic procedures established depends on the size of the organisation; number 
of projects to be considered; direct financial benefit of each project considered by 
itself; the composition of the firm's existing assets and management's desire to 
change that composition; timing of expenditures associated with the projects that 
are finally accepted. 
 
(i) Planning: The capital budgeting process begins with the identification of 
potential investment opportunities.  The opportunity then enters the planning 
phase when the potential effect on the firm's fortunes is assessed and the ability 
of the management of the firm to exploit the opportunity is determined.  
Opportunities having little merit are rejected and promising opportunities are 
advanced in the form of a proposal to enter the evaluation phase. 
(ii) Evaluation: This phase involves the determination of proposal and its 
investments, inflows and outflows.  Investment appraisal techniques, ranging 
from the simple payback method and accounting rate of return to the more 
sophisticated discounted cash flow techniques, are used to appraise the 
proposals.  The technique selected should be the one that enables the manager 
to make the best decision in the light of prevailing circumstances. 
(iii) Selection: Considering the returns and risks associated with the individual 
projects as well as the cost of capital to the organisation, the organisation will 
choose among projects so as to maximise shareholders’ wealth. 
(iv) Implementation: When the final selection is made, the firm must acquire the 
necessary funds, purchase the assets, and begin the implementation of the 
project. 
(v) Control: The progress of the project is monitored with the aid of feedback 
reports.  These reports will include capital expenditure progress reports, 
Review Control
Implement
ation
Implement
Selection Selection Evaluation Evaluation Planning
7.5 
INVESTMENT DECISIONS 
performance reports comparing actual performance against plans set and post 
completion audits. 
(vi) Review: When a project terminates, or even before, the organisation should 
review the entire project to explain its success or failure.  This phase may have 
implication for firms planning and evaluation procedures.  Further, the review 
may produce ideas for new proposals to be undertaken in the future. 
 7.4 TYPES OF CAPITAL INVESTMENT DECISIONS 
There are many ways to classify the capital budgeting decision. Generally capital 
investment decisions are classified in two ways. One way is to classify them on the 
basis of firm’s existence. Another way is to classify them on the basis of decision 
situation. 
 
7.4.1 On the basis of firm’s existence 
The capital budgeting decisions are taken by both newly incorporated firms as well 
as by existing firms. The new firms may require decision making in respect of 
selection of a plant to be installed. The existing firm may require taking decisions 
to meet the requirement of new environment or to face the challenges of 
competition. These decisions may be classified as follows: 
(i) Replacement and Modernisation decisions: The replacement and 
modernisation decisions aim at to improve operating efficiency and to reduce 
cost. Generally, all types of plant and machinery require replacement either 
Types of Capital Investment 
Decisions
On the basis of firm’s 
existence
Replacement and 
Modernisation decisions
Expansion decisions
Diversification decisions
On the basis of 
decision situation
Mutualy exclusive 
decisions
Accept-Reject decisions
Contingent decisions