Sunday 6 December 2015

Investment Decisions and Fundamentals of Value




Investment Decision Rules:

Accept all investments with Net Present Value greater than Zero.

Accept all investments with Rates of Return greater than their Opportunity Costs of Capital





@ time 39.00

An example:

You are considering an investment opportunity that costs $100,000 and promises to return 10%.

A comparable investment in the financial market returns 15%.

A bank offers to lend you $100,000 at 8% with no conditions.


Questions:

1.  Do you invest $100,000 in the investment opportunity?

Answer:  NO

2.  What is the investment's cost of capital?

Answer:  15%.


Reasons:

You should invest the $100,000 in the financial market that returns 15%.

The financial market provides the investing return standards against which other investments are evaluated.

Financing by the bank loan at 8% was irrelevant to the investment decision.

The investment decision and the financing decision are separate and independent decisions.

After you have made the investment decision, thus:
You are considering an investment opportunity that costs $100,000 and promises to return 10%.

A comparable investment in the financial market returns 15%.

Then you make the financing decision, thus:
A bank offers to lend you $100,000 at 8% with no conditions.


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