Factors influencing investment decision
Capital investment decisions are not governed by one or two factors, because the investment problem is not simply one of replacing old equipment by a new one, but is concerned with replacing an existing process in a system with another process which makes the entire system more effective.
We discuss below some of the relevant factors that affects investment decisions:
1. Management Outlook
lf the management is progressive and has an aggressively marketing and growth outlook, it will encourage innovation and favor capital proposals which ensure better productivity on quality or both. In some industries where the product being manufactured is a simple standardized one, innovation is difficult and management would be extremely cost conscious.
In contrast, in industries such as chemicals and electronics, a firm cannot survive, if it follows a policy of ‘make-do’ with its existing equipment. The management has to be progressive and innovation must be encouraged in such cases.
2. Competitor’s Strategy
Competitors’ strategy regarding capital investment exerts significant influence on the investment decision of a company. If competitors continue to install more equipment and succeed in turning out better products, the existence of the company not following suit would be seriously threatened. This reaction to a rival’s policy regarding capital investment often forces decision on a company’
3. Opportunities created by technological change
Technological changes create new equipment which may represent a major change in process, so that there emerges the need for re-evaluation of existing capital equipment in a company. Some changes may justify new investments. Sometimes the old equipment which has to be replaced by new equipment as a result of technical innovation may be downgraded to some other applications.
A proper evaluation of this aspect is necessary, but is often not given due consideration. In this connection, we may note that the cost of new equipment is a major factor in investment decisions. However the management should think in terms of incremental cost, not the full accounting cost of the new equipment because cost of new equipment is partly offset by the salvage value of the replaced equipment. In such analysis an index called the disposal ratio becomes relevant.
Disposal ratio = (Salvage value, Alternative use value) / Installed cost
4. Market forecast
Both short and long run market forecasts are influential factors in capital investment decisions. In order to participate in long-run forecast for market potential critical decisions on capital investment have to be taken.
5. Fiscal Incentives
Tax concessions either on new investment incomes or investment allowance allowed on new investment decisions, the method for allowing depreciation deduction allowance also influence new investment decisions.
6. Cash flow Budget
The analysis of cash-flow budget which shows the flow of funds into and out of the company may affect capital investment decision in two ways.
First, the analysis may indicate that a company may acquire necessary cash to purchase the equipment not immediately but after say, one year, or it may show that the purchase of capital assets now may generate the demand for major capital additions after two years and such expenditure might clash with anticipated other expenditures which cannot be postponed.
Secondly, the cash flow budget shows the timing of cash flows for alternative investments and thus helps management in selecting the desired investment project.
7. Non-economic factors
New equipment may make the workshop a pleasant place and permit more socializing on the job. The effect would be reduced absenteeism and increased productivity. It may be difficult to evaluate the benefits in monetary terms and as such we call this as non-economic factor.
Let us take one more example. Suppose the installation of a new machine ensures greater safety in operation. It is difficult to measure the resulting monetary saving through avoidance of an unknown number of injuries. Even then, these factors give tangible results and do influence investment decisions.