A company invests in capital assets for a variety of reasons. Typically obsolesc

Question

A company invests in capital assets for a variety of reasons. Typically obsolescence, need for additional capacity and stages of a product life cycle aide in the decision making process for capital purchases. If a company has surplus cash or assets they also have the option of distributing the excess to the shareholders in the form of dividends.

Please describe the rationale for a company to either distribute excess or invest in capital assets. Please discuss the product life cycle and desire for growth. Compare the expectations of the shareholders with that of management as it relates to capital acquisitions. You must cite 1 source.

Explanation / Answer

One of the most important objectives of running any business is to maximize shareholder's wealth. The profits earned by the company are frequently reinvested in the business to finance its growth and expansion plans in the form of retained earnings. The company may also decide to distribute its earnings to its shareholders in the form of dividends. However, to maintain a regular dividend payout policy, the company needs to have sufficient profits and funds on an year to year basis.

The policy of the company to retain its profits can result in capital appreciation of the stock which will again benefit the shareholders in terms of higher stock value. While some investors may prefer dividend (as they consider it a regular source of income), others may prefer overall growth in their investment. In order to meet the objectives of both types of investors, the company decide to retain some part of its profits and distribute the remaining part as dividends.

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A product generally passes through 4 different stages - introduction, growth, maturity and decline. It may not be possible to earn profits during the introduction stage as a lot of money is required to invested in creating and establishing the market (to create awareness about the product).

It is during the growth phase that the company starts earning profits and can reinvest the money earned by it in the form of capital acquistions to support its growth and expansion plans. It can further distribute its earnings to shareholders to keep them satisfied and attract more investment from the market. If the focus of the company is to grow its business in multiple areas/markets or product diversification, it may decide to reinvest all of the profits earned by it in the business and provide returns to shareholders in the form of dividends.

During the maturity phase, more investment may be required in capital assets to maintain the already established market and to add more value to the product offerings (in the form of product modifications/improvements).

During the final phase, it may not be possible for the company to maintain its profits and reinvest earnings in the business or distribute dividends.

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While the focus of management may be on the growth of business, investors expect a decent return on their investments. Dividends may appear to be a regular source of income to some investors. On the other hand, some investors may prefer long term returns which may be achieved through the capital appreciation of the stock resulting from investments made in capital acquisitions. Investors, focusing regular returns may not support capital acquisition decisions made by the company. While, the reverse may be true in case of investors looking for returns through growth and expansion of the business.

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