At present, efficient use and allocation of capital are the most important functions of financial management. Practically, this function involves the decision of the firm to commit its funds in long-term assets together with other profitable activities.
However, the decisions of the firm to invest funds in long-term assets needs considerable importance as the same tends to influence the firm’s wealth, size, growth and also affects the business risk. No doubt, the primary consideration of all types of investment decisions is the rate of earning capacity, i.e., rate of return.
But there are other considerations as well, e.g. risk factor. In short, risk factor also plays a significant role in investment decisions.
Generally, investment decisions fall under two broad categories:
(i) Investment in own business; and
(ii) Investment in outside business, i.e., in securities and other companies.
We all know that the primary sources of supplying capital are:
(i) Owners and
(ii) Lenders / Outsiders.
It is also known to us that there is a cost of capital in all types of capital investment in the business Therefore, investment in own business is justified only when the return for the same will be at least equal to the estimated return resulting from the investment by way of relevant cost of capital.
In other words, investment in own business is desirable provided the return from such enterprise is higher than the estimated return on the relevant cost of capital.
The primary purpose, of course, of investment funds in business assets is to produce future economic benefits in such a manner which will cover not only the cost of capital and operating expenses but also will leave a sufficient margin in order to cover the risk which is involved in it.
Investment Involves Risk:
The values of invested capital can, no doubt, be affected due to the following factors:
(i) Advancement in technology leads to an improved and efficient machine which may prove existing machineries worthless; or,
(ii) A change in pattern and design which involves the scrapping of parts or materials or tools lying in stock and which can no longer be used in future; or,
(iii) If the consumers’ tastes and preferences are changed, it is nothing but a loss of value to a company; or,
(iv) Investments made in ‘Receivables’ may prove bad and irrecoverable and so on.
Therefore, adequate consideration relating to investment of capital should always be made since investment involves risk.
Need for Funds:
We all know that funds are required by a firm for its different purposes. Naturally, how much fund is required depends on the nature and types of the business enterprise.
Generally, two well-known classifications may be mentioned below:
(i) Investment in Fixed Assets; and
(ii) Investment in Current Assets (Working Capital).
Fixed assets (e.g., Land and building. Plant and Machinery, Furniture and Fixtures etc.) are acquired not for sale and they are usually owned They help to continue the production function for goods and services in order to earn revenues. Investment in fixed assets must be made in such a way so that they are properly utilised, i.e., must not be idle.
So, investment in fixed assets needs the following further consideration:
(i) Provision to be made for adequate planned capital expenditure,
(ii) Proper evaluation of the project to be made before the actual execution, and
(iii) Estimates and schedules are made for approved capital projects, and so on.
Similarly, current assets (e.g.. Inventories, Debtors, Bills, Cash and Bank balances etc.) are required for working capital purposes. The funds for investment in working capital must also be properly utilised, since the idle working capital will increase the cost.
Since the financial resources are always limited, proper allocation and use of funds are necessary. Besides, limited financial resources leads to a firm considering the alternative courses of action, viz.,
i. Rental — as an alternative to ownership;
ii. Buying— as an alternative to manufacturing.