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Introduction to Investment Decisions

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An investment decision is a well-planned action that allocates financial resources to obtain the highest possible return. The decision is made based on investment objectives, risk appetites, and the nature of the investor, i.e., whether they are an individual or a firm. Perhaps, the two most important factors in considering an investment decisions are risks and returns. Investors and managers dedicate a lot of time to investment planning—these decisions involve massive funds and can be irreversible—impact on the investors and business is long-term. Individuals and corporate investors have to decide between various options—assets, securities, bonds, debentures, gold, real estate, etc. For businesses, investments could be in the form of new ventures, projects, mergers, or acquisitions as well. Investment decisions can also be further classified into short-term and long-term. For example, the final decision may involve a capital expenditure on assets that pay off in the long run or an inv...
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Features of Investment Decisions

Investment Decisions Are Dynamic and Long-term in Nature. Investments are meant for the long term and they have a future probability of profits or losses. Every company hopes that their decisions bring the most amount of profits. Investment Decisions Are Irreversible. Once these decisions are taken, the companies stick to them for a long time. Therefore, it is important that managers make the best decisions on behalf of the company. Investment Decisions Involve High Risk. There is, usually, a high risk associated with the investment functions. As the decisions are either estimation or interpretation, there is hardly any evidence that the decisions would be successful in the long run. Investment Decisions Requires Huge Funds. Investment Decisions Impact the Cost Structure. As the companies commit to all expenses, including rent, insurance, etc., they must take all costs into account for a perfect investment decision. Investment Decisions Require Long-term Commitment. The funds in case o...
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Types of Investment Decisions

1. Strategic investment strategic investment decisions often have significant consequences for the firm in terms of its market presence, success or failure of its operations as well as the fulfillment of its mid- and long-term strategic objectives. 2. Capital expenditure Capital expenditures (CapEx) are funds used by a company to acquire, upgrade, and maintain physical assets such as property, plants, buildings, technology, or equipment. CapEx is often used to undertake new projects or investments by a company. 3. Inventory investment Inventory investment is the change in the stocks of materials, works in process, and finished goods within a firm, industry, or entire economy over a specified period of time 4. Modernization investment Modernization investments are used for the modernization of the plants and machinery of a firm. It may be required to install new machinery to adapt to the growing demands and meet the current demands of the product. A company often invests in modernizatio...
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Investment Decision Rule

There are certain rules which need to be followed while making financial decisions. Any final decision should abide by the following rules: The wealth of the shareholders should be maximized. In order to assess the project's actual profitability, it should take into account all cash flows. It ought to offer a clear-cut, unbiased method of differentiating between successful and unsuccessful projects. It should assist in project ranking based on real profitability. It should be aware that larger cash flows are preferred over smaller ones and that earlier cash flows are preferred over later ones.  It should be easier to select the project that maximizes the value of the owners from a group of initiatives that are mutually exclusive.  It should be a standard that is independent of others and applicable to any imaginable investment project.
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Evaluation Criteria: Non-Discounted Cash Flow

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As discussed before, there are majorly two evaluation criteria for evaluating an investment decision. This blog post will be discussing the second evaluation criteria: Non-Discounted Cash Flow.  A non-discount method of capital budgeting is one that does not consider the time value of money. In other words, all currency earned in the future are assumed to have the same value as today's currency. One example of a non-discount method is the payback method, since it does not consider the time value of money. The payback method simply computes the number of years it will take for an investment to return cash that is equal to the amount invested. The computed number of years is referred to as the payback period. To illustrate, let us assume that a company invests  ₹1, 00,000 today in a project that is expected to generate cash of  ₹ 50,000 for two years followed by  ₹ 10,000 per year for four additional years. Its payback period is two years ( ₹ 50,000 +  ₹ 50,000). ...
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Evaluation Criteria: Discounted Cash Flow (DCF)

 1 ) Payback period (PB) Payback is the number of years required to recover the original cash outlay invested in a project. The project would be accepted if its pay back period is less than the maximum or standard payback period set by management. As a ranking method, it gives highest ranking to the project, which has the shortest payback period and lowest ranking to the project with highest payback period. a) Constant annual cash inflows If the project generates constant annual cash inflows, the payback period can be computed by dividing cash outlay by the annual cash inflow. Payback = Initial Investment/ Annual Cash Inflow  Assume that a project requires an outlay of Rs 50,000 and yields annual cash inflow of Rs 12,500 for 7 years. The payback period for the project is: 50,000/12,500 = 4 years   b) Unequal cash flows In case of unequal cash inflows, the pay back period can be found out by adding up the cash inflows until the total is equal to the initial ...
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Examples

A simple example to explain financial decision could be: A long term capital decision would be to buy machinery for production. This is important as it affects the long term earnings of the firm and a short term investment is related to levels of cash, inventories, etc. These decisions affect day to day working of the business. A few outstanding examples of great financial planning and management from around the world are as follows: 1.  DP World Plan and Caisse de Depot et Placement du Québec (CDPQ) jointly invested $5 billion in three well-known UAE assets: Jebel Ali Free Zone (JAFZ), the largest free zone in the world and located in the middle east. Jebel Ali Port (JAP), which created a trade corridor between the east and the west. National Industries Park (NIP), which dispersed its manufacturing and processing businesses over an area of 21 square kilometers. A logistics chain made up of 8700 international enterprises and more than 3.5 billion consumers globally was made availab...
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