Investment Decision
One of the most important finance functions is to intelligently allocate capital to long term assets. This
activity is also known as capital budgeting. It is important to allocate capital in those long term assets so
as to get maximum yield in future. Following are the two aspects of investment decision
Evaluation of new investment in terms of profitability
Comparison of cut off rate against new investment and prevailing investment.
Since the future is uncertain therefore there are difficulties in calculation of expected return. Along with
uncertainty comes the risk factor which has to be taken into consideration. This risk factor plays a very
significant role in calculating the expected return of the prospective investment. Therefore while
considering investment proposal it is important to take into consideration both expected return and the
risk involved.
Investment decision not only involves allocating capital to long term assets but also involves decisions of
using funds which are obtained by selling those assets which become less profitable and less productive.
It wise decisions to decompose depreciated assets which are not adding value and utilize those funds in
securing other beneficial assets. An opportunity cost of capital needs to be calculating while dissolving
such assets. The correct cut off rate is calculated by using this opportunity cost of the required rate of
return (RRR)
The required assets fall into two groups:
(i) Long-term Assets (fixed assets – plant & machinery land & buildings, etc.,) which involve huge
investment and yield a return over a period of time in future. Investment in long-term assets is popularly
known as “capital budgeting”. It may be defined as the firm’s decision to invest its current funds most
efficiently in fixed assets with an expected flow of benefits over a series of years.
(ii) Short-term Assets (current assets – raw materials, work-in-process, finished goods, debtors, cash,
etc.,) that can be converted into cash within a financial year without diminution in value. Investment in
current assets is popularly termed as “working capital management”. It relates to the management of
current assets.
It is an important decision of a firm, as short-survival is the prerequisite for long-term success. Firm
should not maintain more or less assets. More assets reduces return and there will be no risk, but having
less assets is more risky and more profitable. Hence, the main aspects of working capital management
are the trade-off between risk and return.
Financial Decision
Financial decision is yet another important function which a financial manger must perform. It is
important to make wise decisions about when, where and how should a business acquire funds. Funds
can be acquired through many ways and channels. Broadly speaking a correct ratio of an equity and
debt has to be maintained. This mix of equity capital and debt is known as a firm’s capital structure.
A firm tends to benefit most when the market value of a company’s share maximizes this not only is a
sign of growth for the firm but also maximizes shareholders wealth. On the other hand the use of debt
affects the risk and return of a shareholder. It is more risky though it may increase the return on equity
funds.
A sound financial structure is said to be one which aims at maximizing shareholders return with
minimum risk. In such a scenario the market value of the firm will maximize and hence an optimum
capital structure would be achieved. Other than equity and debt there are several other tools which are
used in deciding a firm capital structure.
What is working capital management?
Working capital management – defined as current assets minus current liabilities – is a business tool
that helps companies effectively make use of current assets and maintain sufficient cash flow to meet
short-term goals and obligations. By effectively managing working capital, companies can free up cash
that would otherwise be trapped on their balance sheets. As a result, they may be able to reduce the
need for external borrowing, expand their businesses, fund mergers or acquisitions, or invest in R&D.
Working capital is essential to the health of every business, but managing it effectively is something of a
balancing act. Companies need to have enough cash available to cover both planned and unexpected
costs, while also making the best use of the funds available. This is achieved by the effective
management of accounts payable, accounts receivable, inventory, and cash.
Working capital formula
Working capital is calculated by subtracting current liabilities from current assets. That means that the
working capital formula can be illustrated as:
Working capital = current assets – current liabilities
Current assets include assets such as cash and accounts receivable, and current liabilities include
accounts payable.
Other important working capital metrics include:
Days Sales Outstanding (DSO) – the average number of days taken for the company’s customers to pay
their invoices.
Days Payables Outstanding (DPO) – the average number of days that the company takes to pay its
suppliers.
Days Inventory Outstanding (DIO) – the average number of days that the company takes to sell its
inventory.
Cash Conversion Cycle (CCC) – the average time taken for the company to convert its investment in
inventory into cash.
CCC is calculated as follows:
CCC = DIO + DSO – DPO
The shorter a company’s CCC, the sooner it is converting cash into inventory and then back to cash.
Companies can reduce their cash conversion cycle in three ways: by asking customers to pay faster
(reducing DSO), extending payment terms to suppliers (increasing DPO) or reducing the time that
inventory is held (reducing DIO).
Objectives of working capital management
Working capital is an essential metric for businesses to pay attention to, as it represents the amount of
capital they have on hand to make payments, cover unexpected costs, and ensure business runs as
usual. However, working capital management isn’t that simple, and there can be multiple objectives of a
working capital management program, including:
Meeting obligations. Working capital management should always ensure that the business has enough
liquidity to meet its short-term obligations, often by collecting payment from customers sooner or by
extending supplier payment terms. Unexpected costs can also be considered obligations, so these need
to be factored into the approach to working capital management, too.
Growing the business. With that said, it’s also important to use your short-term assets effectively,
whether that means supporting global expansion or investing in R&D. If your company’s assets are tied
up in inventory or accounts payable, the business may not be as profitable as it could be. In other words,
too cautious an approach to working capital management is suboptimal.
Optimizing capital performance. Another working capital management objective is to optimize the
efficiency of capital usage – whether by minimizing capital costs or maximizing capital returns. The
former can be achieved by reclaiming capital that is currently tied up to reduce the need for borrowing,
while the latter involves ensuring the ROI of spare capital outweighs the average cost of financing it.
Effective working capital management
Speeding up the CCC can improve a company’s working capital position, but it may also have other
consequences. For example, there is a risk that reducing inventory levels could negatively impact your
ability to fulfil orders.
Where DPO is concerned, your accounts payable is also your suppliers’ accounts receivable – so if you
pay suppliers later, you may be improving your own working capital at the expense of your suppliers’
working capital. This may have an adverse effect on your relationships with suppliers and could even
make it difficult for cash-strapped suppliers to fulfil your orders on time.
Effective working capital management therefore means taking steps to improve the company’s working
capital position without triggering adverse consequences elsewhere in your supply chain. This might
include reducing DSO by putting in place more efficient invoicing processes, so that customers receive
your invoices sooner. Or it might mean adopting an early payment program that enables your suppliers
to receive payment sooner than they would otherwise.
Different Types of Working Capital:
1. Temporary Working Capital
Temporary working capital is the capital required by the business during some specific times of the year.
For example, this capital may be required in the festive season owing to the immediate demands of the
business. This requirement is considered temporary and changes as per the business’ operations and
market situations. This also means you just require a short term loan to fund your business and can
repay it soon after, when the cash starts rolling in.
2. Permanent Working Capital
The permanent working capital is the amount of money required to make liability payments even before
you are able to convert assets or invoices into cash. This is also known as the operating cycle and many
businesses require an ongoing, sometimes permanent, solution to fill in this gap. Also known as fixed
working capital or hardcore working capital, this is the minimum working capital required to function
smoothly.
3. Gross & Net Working Capital
Gross working capital is the total of the company’s assets. These assets are basically the ones that can
be converted to cash within one year. The assets typically include:
Cash
Accounts Receivable
Marketable Securities like stocks
Short-Term Investments
The preferred way to express positive working capital is the ratio of current assets to current liabilities.
The networking capital of the business is the difference between gross working capital and current
liabilities.
4. Negative Working Capital
A shortfall or deficit is known as negative working capital and reflects an excess of current liabilities over
current assets. Negative working capital arises when the current liabilities exceed the current assets. In
other words, there is more short-term debt compared to short-term assets. In the case of working
capital, it could be good as a company with negative working capital funds its growth in sales by
effectively borrowing from its suppliers and customers. When managed properly, negative working
capital could be a way to fund your business growth in sales with other people’s money.
5. Reserve Working Capital
Reserve working capital is a type of fund a business maintains over and above the working capital
required. Businesses use such funds as a contingency for unexpected market situations or opportunities.
The reserve working capital refers to the short term financial arrangement made by the business units
to meet any changes or uncertainties.
6. Regular Working Capital
Regular working capital is the least amount of capital required by a business to carry out its day-to-day
business operations. For example, making a monthly payment of salaries and wages and overhead
expenses for processing raw materials required for the business. Businesses need to maintain the
appropriate level of regular working capital for stable operations.
7. Seasonal Working Capital
This working capital refers to the increased amount of working capital a business requires during the
peak season of the year. Businesses that deal in the production or manufacturing of products or provide
services that have seasonal demands need to maintain a seasonal working capital. It can be considered
as a form of reserve working capital but only to adapt to the sudden change and seasonal fluctuations in
the market. Seasonal working capital is considered as that temporary increase in working capital. It is
only applicable to businesses that impact seasons, for example, the manufacturer of raincoats and
umbrellas for whom the relevant season is monsoon. Normally, their working capital requirement would
increase in that season due to higher demand and sales and then go down as the collection from
debtors is more than sales.
8. Special Working Capital
A special working capital loan is a rise in the temporary working capital that occurs due to a special
event that normally does not occur. It has no basis to forecast and has rare occurrences normally. For
example, award functions take place once every year, and such events require a large amount of
working capital to cover the expenses successfully. A special working capital loan is the ideal way to
cover the complete cost of such events. Although big companies and businesses can avail collateral
loans, mostly small businesses cannot afford to pledge collateral.
Benefits of Working Capital Loans
The advantages of working capital loans are as follows:
No restriction on the use of loan funds
The working capital loan is easy to avail with quick disbursement or drawdown
Loan extended on the credentials of the business and do not require any collateral
A reasonable rate of interest and typically short tenure of loan, maybe 12 months
No restriction on the use of funds
What is Net Present Value (NPV) in Project Management?
Net present value (NPV) refers to the difference between the value of cash now and the value of cash at
a future date. NPV in project management is used to determine whether the anticipated financial gains
of a project will outweigh the present-day investment — meaning the project is a worthwhile
undertaking. Generally, an investment with a positive NPV will be profitable and therefore given a green
light for consideration, while an investment with a negative NPV will result in a financial loss, and may
not be undertaken.
What Is Internal Rate of Return (IRR)?
The internal rate of return (IRR) is a metric used in financial analysis to estimate the profitability of
potential investments. IRR is a discount rate that makes the net present value (NPV) of all cash flows
equal to zero in a discounted cash flow analysis.
IRR calculations rely on the same formula as NPV does. Keep in mind that IRR is not the actual dollar
value of the project. It is the annual return that makes the NPV equal to zero
What is the Payback Method?
The payback period is the time required to earn back the amount invested in an asset from its net cash
flows. It is a simple way to evaluate the risk associated with a proposed project. An investment with a
shorter payback period is considered to be better, since the investor's initial outlay is at risk for a shorter
period of time. The calculation used to derive the payback period is called the payback method. The
payback period is expressed in years and fractions of years. For example, if a company invests $300,000
in a new production line, and the production line then produces positive cash flow of $100,000 per year,
then the payback period is 3.0 years ($300,000 initial investment ÷ $100,000 annual payback).
Risk-Return in Portfolio
So far our analysis of risk-return was confined to single assets held in isolation. In real world, we rarely
find investors putting their entire wealth into single asset or investment. Instead they build portfolio of
investments and hence risk-return analysis is extended in context of portfolio.
A portfolio is composed of two or more securities. Each portfolio has risk-return characteristics of its
own. A portfolio comprising securities that yield a maximum return for given level of risk or minimum
risk for given level of return is termed as ‘efficient portfolio’. In their Endeavour to strike a golden mean
between risk and return the traditional portfolio managers diversified funds over securities of large
number of companies of different industry groups.
However, this was done on intuitive basis with no knowledge of the magnitude of risk reduction gained.
Since the 1950s, however, a systematic body of knowledge has been built up which quantifies the
expected return and riskiness of the portfolio. These studies have collectively come to be known as
‘portfolio theory’.
Various Types of Investment Decisions
Inventory Investment
It includes decisions taken by the firm for the procurement of an adequate amount of raw materials.
Maintaining the right stock of materials is important for ensuring the smooth functioning of the
business. All expenses that a firm incurs on stock maintenance are treated in the category of
investment.
Replacement Investment
These decisions are related to the replacement of old or obsolete assets with new ones due to
modernization. The firm decides which all fixed assets need to be replaced and what new assets to be
purchased after replacing them.
Strategic Investment Expenditure
Strategic investment expenditure decisions are taken for improving the power of a firm in the market.
The expenditure on these expenditures provides benefits in long term and does not yield immediate
return.
Modernization Investment Expenditure
Firms incur this expenditure for upgrading their technology used in the production process. Decisions
are taken for adopting the latest and better technology in place of the old one for increasing efficiency
and lowering the overall cost. This is also known as a process of capital deepening.
Expansion Investment
Expansion investment decisions are meant for expanding the size and production capacity of a firm due
to the increase in demand. Here, the firm decides to extend its fixed assets for producing more products
thereby enhancing its efficiency. Investment undertaken for expansion of firm size is also termed as
capital widening.
Expansion Investment On New Business
These decisions are taken by organization for starting of a new business or to diversify its risk by starting
a new line of production. Firm needs to purchase a new set of machinery for diversifying its business
which requires a huge amount of investment.
What is the Investment Decision Process?
Understanding the client
Understanding a client or investor’s needs, risk tolerance, and tax status are essential to any investment
process.
Having gathered an understanding of the client’s goals and constraints, the client’s portfolio
management process must be benchmarked, which helps evaluate the performance and determine
whether the client’s objectives have been met.
Asset allocation decision
In this step, fixed-income securities, equity, real estate, etc., are allocated across different asset classes.
Investing in domestic assets or foreign assets is also a part of this process. The investor will decide after
examining the macroeconomic and market conditions.
Objectives of Financial Management
The financial management is generally concerned with procurement, allocation and control of financial
resources of a concern. The objectives can be-
To ensure regular and adequate supply of funds to the concern.
To ensure adequate returns to the shareholders which will depend upon the earning capacity, market
price of the share, expectations of the shareholders.
To ensure optimum funds utilization. Once the funds are procured, they should be utilized in maximum
possible way at least cost.
To ensure safety on investment, i.e, funds should be invested in safe ventures so that adequate rate of
return can be achieved.
To plan a sound capital structure-There should be sound and fair composition of capital so that a
balance is maintained between debt and equity capital.
Functions of Financial Management
Estimation of capital requirements: A finance manager has to make estimation with regards to capital
requirements of the company. This will depend upon expected costs and profits and future programmes
and policies of a concern. Estimations have to be made in an adequate manner which increases earning
capacity of enterprise.
Determination of capital composition: Once the estimation have been made, the capital structure have
to be decided. This involves short- term and long- term debt equity analysis. This will depend upon the
proportion of equity capital a company is possessing and additional funds which have to be raised from
outside parties.
Choice of sources of funds: For additional funds to be procured, a company has many choices like-
Issue of shares and debentures
Loans to be taken from banks and financial institutions
Public deposits to be drawn like in form of bonds.
Choice of factor will depend on relative merits and demerits of each source and period of financing.
Investment of funds: The finance manager has to decide to allocate funds into profitable ventures so
that there is safety on investment and regular returns is possible.
Disposal of surplus: The net profits decision have to be made by the finance manager. This can be done
in two ways:
Dividend declaration - It includes identifying the rate of dividends and other benefits like bonus.
Retained profits - The volume has to be decided which will depend upon expansional, innovational,
diversification plans of the company.
Management of cash: Finance manager has to make decisions with regards to cash management. Cash is
required for many purposes like payment of wages and salaries, payment of electricity and water bills,
payment to creditors, meeting current liabilities, maintainance of enough stock, purchase of raw
materials, etc.
Financial controls: The finance manager has not only to plan, procure and utilize the funds but he also
has to exercise control over finances. This can be done through many techniques like ratio analysis,
financial forecasting, cost and profit control, etc.
Objectives of Investment?
1. To Keep Money Safe
Capital preservation is one of the primary objectives of investment for people. Some investments help
keep hard-earned money safe from being eroded with time. By parking your funds in these instruments
or schemes, you can ensure that you do not outlive your savings. Fixed deposits, government bonds, and
even an ordinary savings account can help keep your money safe. Although the return on investment
may be lower here, the objective of capital preservation is easily met.
2. To Help Money Grow
Another one of the common objectives of investing money is to ensure that it grows into a sizable
corpus over time. Capital appreciation is generally a long-term goal that helps people secure their
financial future. To make the money you earn grow into wealth, you need to consider investment
objectives and options that offer a significant return on the initial amount invested. Some of the best
investments to achieve growth include real estate, mutual funds, commodities, and equity. The risk
associated with these options may be high, but the return is also generally significant.
3. To Earn a Steady Stream of Income
Investments can also help you earn a steady source of secondary (or primary) income. Examples of such
investments include fixed deposits that pay out regular interest or stocks of companies that pay
investors dividends consistently. Income-generating investments can help you pay for your everyday
expenses after you have retired. Alternatively, they can also act as excellent sources of supplementary
income during your working years by providing you with additional money to meet outlays like college
expenses or EMIs.
4. To Minimize the Burden of Tax
Aside from capital growth or preservation, investors also have other compelling objectives for
investment. This motivation comes in the form of tax benefits offered by the Income Tax Act, 1961.
Investing in options such as Unit Linked Insurance Plans (ULIPs), Public Provident Fund (PPF), and Equity
Linked Savings Schemes (ELSS) can be deducted from your total income. This has the effect of reducing
your taxable income, thereby bringing down your tax liability.
5. To Save up for Retirement
Saving up for retirement is a necessity. It is essential to have a retirement fund you can fall back on in
your golden years, because you may not be able to continue working forever. By investing the money
you earn during your working years in the right investment options, you can allow your funds to grow
enough to sustain you after you’ve retired.
6. To Meet your Financial Goals
Investing can also help you achieve your short-term and long-term financial goals without too much
stress or trouble. Some investment options, for instance, come with short lock-in periods and high
liquidity. These investments are ideal instruments to park your funds in if you wish to save up for short-
term targets like funding home improvements or creating an emergency fund. Other investment options
that come with a longer lock-in period are perfect for saving up for long-term goals
