Capital investment decisions are those decisions that involve current outlays in return for a stream of benefits in future years. it is true to say that all of a firm’s expenditures are made in expectation of realizing future benefits. The distinguishing feature between short-term decisions and capital investment (long-term) decisions is time.
Generally, we can classify short-term decisions as those that involve a relatively short time horizon, say one year, from the commitment of funds to the receipt of the benefits On the other hand. capital investment decisions are those decisions where a significant period of time elapses between the outlay and the recoupment of the investment. We shall see that this commitment of funds for a significant period of time involves an interest cost, which must be brought into the analysis. with short-term decisions, funds are committed only for short periods of time, and the interest cost is normally so small that it can be ignored.
Capital investment decisions normally represent the most important decisions that an organization makes, since they commit a substantial proportion of a firm’s resources to actions that are likely to be irreversible. such decisions
are applicable to all sectors of society. Business firms’ investment decisions include investments in plant and machinery, research and development, advertising and warehouse facilities investment decisions in the public sector
include new roads, schools and airports. individuals’ investment decisions include house-buying and the purchase of consumer durable. in this page, we shall examine the economic evaluation of the desirability of investment
proposals. we shall concentrate on the investment decisions of business firms, but the same principles, with modifications, apply to individuals, and the public sector.
For most of this chapter we shall assume that the investments appraised are in firms that are all equity financed. in other words, projects are financed by the issue of new ordinary shares or from retained earnings, Later in the
chapter we shall relax this assumption and assume that projects are financed by a combination of debt (i.e. borrowed funds) and equity capital. you will find throughout the chapter that mathematical formula and simple arithmetic
are used to compute the values that are used to evaluate investments. you can use either approach. if you have an aversion to mathematical formula you should ignore the formula calculations. All of the calculations are repeated using non-formula approaches.
Opportunity Cost of an Investment
Investors can invest in securities traded in financial markets. if you prefer to avoid risk, you can invest in government securities which will yield a fixed return.On the other hand,you may prefer to invest in risky securities such as the ordinary shares of companies quoted on the stock exchange, if you invest in the ordinary shares of a company, you will find that the return will vary from year to year, depending on the performance of the company and its future expectations. Investors normally prefer to avoid risk if possible, and will generally invest in risky securities only if they believe that they will obtain a greater return for the increased risk.
Suppose that risk-free gilt-edged securities issued by the government yield a return of ’10 per cent. Currently government securities yield a return that is significantly less than 10 per cent but we shall use 10 per cent in order to simplify the calculations.
With a return available of 10 per cent on government securities you should only be prepared to invest in ordinary shares if you expect a return in excess of 10 per cent. let us assume that you require an expected return of 15 per cent to induce you to invest in ordinary shares in preference to a risk free security. Note that expected return means the
estimated average future return. You would expect to earn, on average, 15 per cent, but in some years you might earn more and in others considerably less! .
Suppose you invest in company X ordinary shares. would you want company X to invest your money in a capital project that gives less than 15 per cent? Surely not.
Assuming the project has the same risk as the alternative investments in shares of other companies that are yielding a return of 15 per cent. You would prefer company X to invest in other companies’ ordinary shares at 15 per cent or, alternatively, to repay your investment so that you could invest yourself at 15 per cent.
The rates of return that are available from investments in securities in financial markets such as ordinary shares and government gilt-edged securities represent the opportunity cost of an investment in capital projects; that is, if cash is invested in the capital project it cannot be invested elsewhere to earn a return. A firm should therefore invest in capital
projects only if they yield a return in excess of the opportunity cost of the investment. The opportunity cost of the investment is also known as the minimum required rate of return, cost of capital, discount rate or interest rate.
The return on securities traded in financial markets provides us with the opportunity costs, that is the required rates of return available on securities. The expected returns that investors require from the ordinary shares of different companies vary because some companies’ shares are more risky than others. The greater the risk the greater the expected returns.
Consider below chart.
You can see that as the risk of a security increases the return that investors require to compensate for the extra risk increases, Consequently, investors will expect to receive a return in excess of 15 per cent if they invest in securities that have a higher risk than company X ordinary shares, if this return was not forthcoming, investors would not purchase high-risk securities. it is therefore important that companies investing in high-risk capital projects earn higher returns to compensate investors for this risk You can also see that a risk-free security such as a gilt-edged government security yields the lowest return,i.e 10 percent Consequently,if a firm invests in a project with zero risk,it should earn a return in excess of 10 percent. if the project does not yield this return and no other projects are available then the funds earmarked for the project should be repaid to shareholders as dividends. The shareholders could then invest the funds themselves at 10 percent.
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