Edited by Seema Yadav
The Investment Decision refers to the decision which is made by the investors or the top-level management with respect to the amount of funds to be deployed in the investment opportunities.
An investment decision revolves around spending capital on assets that will yield the highest return for the company over the desired time period. In other words, the decision is about what to buy so that the company will gain the most value.
The investment decision also concerns about what specific investments to be made. Since there is no guarantee of a return for most investments, the finance department must determine an expected return. This return is not guaranteed, but the average of return on an investment if it were to be made many times.
The investments must meet three main criteria:
- It must maximize the value of the firm, after considering the amount of risk the company is comfortable with risk aversion.
- It must be financed appropriately.
- If there is no investment opportunity that fills (1st) and (2nd), the cash must be returned to shareholder in order to maximize shareholder value.
TYPES OF INVESTMENT DECISION
Long Term Assets
The decision of investing funds in the long term assets is known as Capital Budgeting. Thus, Capital Budgeting is the process of selecting the asset or an investment proposal that will yield returns over a long period.
The first step involved in Capital Budgeting is to select the asset, whether existing or new on the basis of benefits that will be derived from it in the future.
The next step is to analyse the proposal’s uncertainty and risk involved in it. Since the benefits are to be accrued in the future, the uncertainty is high with respect to its returns.
Finally, the minimum rate of return is to be set against which the performance of the long-term project can be evaluated.
The investment made in the current assets or short term assets is termed as Working Capital Management. The working capital management deals with the management of current assets that are highly liquid in nature.
The investment decision in short-term assets is crucial for an organization as a short term survival is necessary for long-term success. Through working capital management, a firm tries to maintain a trade-off between the profitability and the liquidity.
In case a firm has an inadequate working capital i.e. fewer funds invested in the short term assets, then the firm may not be able to pay off its current liabilities and may result in bankruptcy. Or in case the firm has more current assets than required, it can have an adverse effect on the profitability of the firm.
Thus, a firm must have an optimum working capital that is necessary for the smooth functioning of its day to day operations.