FIXED CAPITAL INVESTMENTS (INVESTMENT IN FIXED ASSETS)

 1.      Investment and Different Meanings of Capital

      Investment means acquiring assets (tying up money in assets). When a business acquires assets (whether current asset or fixed assets) it makes in investment. We can also say that anything that causes an increase on the left-hand side of the balance sheet is investment because assets are listed on the left-hand side of the balance sheet. When a business makes an investment (in other words when a business acquires assets) it ties up money in assets. So, investment can also be defined as tying up money in assets because acquiring assets requires spending money.

      There are two meanings of capital in business. They are explained below:

      Capital can be defined as the amount invested in the business by the owners (shareholders’ equity).

      Capital also means the assets of the business. As you remember there are two types of assets, which are current assets and non-current (fixed) assets.

      Current assets in finance are also called as working capital. It is called working capital because businesses need current assets in order to carry out its activities.

      Non-current (fixed) assets are called fixed capital.

      Investment in current assets is called working capital management.

      Investment in fixed assets is called fixed capital investments (capital budgeting).

      Investment in financial instruments (investment in securities) is called financial investment.

2.   Fixed Capital Investments

      Fixed capital investments refer to planned investments in fixed assets such as plants, buildings, machinery and equipment, vehicles, furniture and fixtures, land improvements (such as pipelines).

      Fixed capital investments require large amount of money. In other words large amount of money is tied up in fixed assets.

      That is why investment in fixed capital (fixed assets) requires detailed and careful planning.

      Planning investment in fixed capital is accomplished by preparing and analyzing an investment project.

      Capital budget lists the planned, analyzed and accepted fixed capital investments.

2.   Types of Fixed Capital Investments

      Replacement projects (Maintenance of Business): These are investments necessary to replace worn-out or damaged equipment (non-serviceable equipment). The purpose is to maintain the business. Otherwise the business cannot produce the goods or provide the services because the equipment is non-serviceable.

Replacement projects (Modernization): This category includes projects to replace serviceable but out-modeled equipment. The purpose is to lower the costs of labor, materials, and other inputs such as energy.

Capacity expansion of existing products or services: Projects to increase output of existing products or services. The purpose is to exploit the unsatisfied  demand.

 

Expansion into new products or markets: Projects necessary to produce new products, provide new services or to expand into new geographic areas not currently being served. The purpose is to adress the needs of the customers that haven’t been adressed yet.

 

Mandatory investments: Investments necessary to comply with laws and regulations. For example a law or regulation may require the businesses operating in a certain area of activity to use pollution control equipment. Every business operating in that area of activity has to own that equipment. Otherwise they may be fined or their activities may be suspended by the authorities. Acquiring the necessary pollution control equipment is a mandatory investment.

Other investments: Non-revenue generating investments such as new cars, new furniture and fixtures etc. The purpose is to improve the image of the business or its owners or to create a positive impact on the others (customers, suppliers, etc.).

3.      Components of Investment Project

      An investment project has three components. They are economic analysis, technical analysis and financial analysis.

      Economic analysis is conducted to find out whether there is enough demand for the product or the service. Following issues are addressed in the economic analysis:

• Detailed description of the product or the service,
• Is there enough demand for the product or the service?
• Does the project have strong commercial prospects?
• A review of the market,
• Target customers,
• Competition in the sector,
• Expected market share and sales volume,
• Pricing strategy,
• Legal issues,
• Location and why the location is chosen?

      In economic analysis market research and forecasting is important.

      Technical analysis deals with the technical aspects of the project and addresses the following issues:

• How do we produce the good or provide the service. (Process planning)
• At this stage fixed assets necessary for the project in order to produce the goods or provide the services are determined along with their costs.
• Materials that are necessary to produce the good or provide the service are determined along with their quantities.
• Labor requirements are also determined

       Technical knowledge is important at this stage.

      Financial Analysis: What are the expected revenues and expenses. Forecasting is important.

      Cash flow tables are prepared and analyzed in financial analysis.

      Preparing an investment project requires team work (marketing, engineers, finance experts).

4.      Investment Project Cash Flows

      Cash flows (actual cash inflows and outflows) are considered, not the accounting profit.

      Investment cash flows: Cash outlays to acquire the fixed assets necessary for the project and other cash outflows related to project preperation and analysis activities.

      Operating cash flows: Cash inflows due to revenues received from the sale of goods or services, and cash outflows due to costs and expenses related to production, delivery, marketing of goods or services.

      Working capital requirements:

• Initial investment in working capital (initial investment in inventory, receivables, cash, and prepayments),
• Additional investment in working capital due to the increase in sales volume (due to the increase in the level of activity),
• Initial investment and additional investment in working capital are considered cash outflows.
• If the working capital requirement decreases as a result of decrease in sales volume this is a disinvestment flow (money tied up in working capital is freed) and considered as cash inflow.
• At the end of the project’s economic life remaining amount tied up in working capital is freed.

      Disinvestments flows: Proceeds expected to be received from the sale of fixed assets related to the project at the end of the project’s economic life. Disinvestment flows are considered as cash inflows.

      Cash flow tables show the investment cash flows, operating cash flows, working capital requirements, and disinvestment flows for each year.