Financial Economics

6

FIRM INVESTMENT DECISIONS

Firms continually invest funds in assets, and these assets produce cash flows that the company may then either reinvest in more assets or pay to the owners. Capital is the company's total assets, including both tangible and intangible assets. Capital includes both physical assets (such as land, buildings, equipment, and machinery) and assets that represent property rights, such as accounts receivable, securities, patents, and copyrights. Capital investment refers to a company's investment in new assets, that is, additions to the existing capital stock.¹

Capital budgeting decisions refer to financial decisions regarding the use of a company's scarce resources in making capital investments, and thus represent decisions regarding long-term use of capital. Whereas some capital budgeting decisions are routine and do not change the course or risk of a company, there are also strategic capital budgeting decisions that will either have an impact on the company's future market position in its current product lines or permit it to expand into a new product line. Moreover, capital budgeting decisions may involve large commitments to particular capital projects with widely differing degrees of irreversibility. Thus, capital budgeting decisions can play a prominent role in determining whether a company will be successful over the longer term.

The company's capital budget may involve making a number of distinct decisions, each referred to as a project. A capital project ...