In all business organizations, a number of proposals are made for the addition of facilities to increase profitability. The managers concerned with product planning or production place emphasis on the deployment of a better technology with a view to achieving higher production at lower cost. One important way to regulate such proposal is to lay down a policy pertaining to investment in fixed assets. Here, we give some samples relating to such proposals.
A plywood-making industry became worried about the increasing cost of production of one of its plants located in Tamil Nadu. A cost analysis revealed that the plants located in North India were getting raw material at a lower cost than that in Tamil Nadu.
It was, therefore, decided that no further investment in fixed assets should be made at the plants in Tamil Nadu; that only the purchase of miscellaneous equipment and spare parts will be allowed; that attempts will be made to ensure that the existing capacities of the plants located in North India are gradually increased; and that the plant located in Tamil Nadu will be discounted.
The policy relating to the investment in fixed assets should be administered with great caution. A change in government policies and uncertainty of technology often tempt the management to give serious thoughts to the varied problems of investment in fixed assets. If a company deals in wide variety of production lines with a view to increase its profitability, heavy investment in fixed capital may be justified.
Minimum Rate of Return of Investment in fixed assets
Most firms concentrate on the minimum rate of return that must be anticipated, if capital is employed in a specific proposal. For example, a company may decide that the investment in new assets must earn at least 5% on the initial investment after making the necessary provision for depreciation and taxes.
All those proposals which yield less than the desired return will then have to be dropped in the very first instance. This sort of policy is quite useful, for the method of estimating the return is quite well defined. The depreciation interest, taxes, net investment and other items can be treated in quite a different manner.
It is largely believed that the permissible rate of return should be the average cost of capital to the company. The minimum rate of return can be properly estimated if due consideration is given to such factors as the desire for expansion, the size of existing funds, plans about future procurement of funds, and assessment of risk. As most executives, who make proposals for investment in fixed assets tend to be quite optimistic in assessing the benefits that are likely to flow from the products, it is desirable that the management should get a high rate of return.
Capital Budgeting in regulating fixed assets investment
In regulating investment of fixed assets, a company quite often has a variety of plans that can be effectively financed. The technique which is widely utilized to screen various investment proposals is commonly known as capital budgeting.
The screening of a proposal calls for the identification of alternatives, feasibility studies, cash flow forecasts, assessments of economic worth vis-a-vis the degree of risk involved, and expected rate of return. Because of its crucial importance, an analysis of various proposals must be done with great caution, for the effective functioning of subsequent plans will depend on the thoroughness with which proposals have been screened.
The whole task will be simplified by screening those proposals which are not in conformity with purchase, production, personnel and finance policies.
Effective investment criteria should have the following features:
- It should clearly screen the projects which are to be accepted or dropped;
- It should provide a logical base for the ranking of projects in the order of their priority;
- It should furnish a scientific basis for choice from among alternatives.
The important technique of screening investment proposals includes the following:
- Payback method;
- Accounting rate of return;
- Net present value method;
- Internal rate of return;
- Profitability index.
A firm may use any one of those methods. However, the method to be employed by a particular firm depends on circumstances. A big firm may use more than one method for project appraisal, while a smaller one may stick to one method. Though these appraisal techniques can help the management to make an effective investment decision, managers should utilize their discretion in arriving at a particular decision by giving due consideration to intangible factors as well.