Investment Decision-Making (Long-Term)

This section will examine some of the ways in which financial information can be used to help in the evaluation of capital investment decisions. Capital investment decisions typically involve a substantial initial cash outflow or payment to purchase a productive asset of some sort (a machine, a company, etc.), followed by a series of improved cash inflows reflecting cost savings or additional contribution earned over the asset's useful life. The initial cash outlay to purchase an asset can be determined fairly easily since it occurs at the present time. However, the productive life of a capital asset may be very long and attempting to forecast the cash inflows arising from a particular investment over many years is inevitably highly subjective.

Relevant Costing

All financial decisions, both short-term and long-term, should be evaluated using the relevant costing approach introduced in week 10. We applied this approach last week to short-term, operational decisions in which the direct cash-flow consequences of a decision are quite easy to evaluate (although we noted that even short-term decisions can sometimes give rise to important long-term indirect effects that are difficult to quantify). Whereas short-term decisions can normally be evaluated on a variable costing basis (i.e., the fixed overheads will be unaffected by most short-term decisions) long-term investment decisions are more likely to alter the level of fixed overhead costs incurred each year, so that a variable costing approach will often fail to show the full cash-flow consequences of an investment decision.