How much should you invest and what assets should you invest in?
Criterion: To maximise the returns to and wealth of the investors.
The value of the firm is increased by
- cash flows generated by the firm which support the price of the stock or
- the dividend returned to the owners.
An important characteristic of investing decision is how you approach this problem: You should focus on the cash flows instead of accruals.
- Expenses vs. Cash Outflows
- Purchase of capital asset
- is cash outflow
- Recognition of depreciation expense
- is not cash outflow
-Revenues vs Cash Inflows
- Borrowing funds
- is cash inflow
Focus of cash flows: Free Cash Flows and Dividend
Focus on accruals: Earnings
The investing decisions by the firm typically have long term consequences to the firm over many years (3 years to 100 years).
When investing, the investors have a projection of what the future cash inflows and future cash outflows of the firms might be but the investors cannot be certain of these future cash flows.
Therefore, the investors also need to focus on the significant risks associated with this projections of future cash flows when making their investing decision..