Investment Decisions

Abstract

Investment decisions pose an important problem to businessmen for two reasons. They involve the commitment of substantial sums of money, at least in relation to the firm’s resources, and they offer recovery of the funds over a lengthy period of time. If an error is made in allocating funds to a significant investment project the managers of the business will find it very difficult and often very expensive to reverse the mistake. On a simple level it might seem sensible to allocate funds to any project which can be financed and which yields a “reasonable” reward on the capital invested. However, apart from the problem of determining what counts as a “reasonable” return in each particular case, this approach fails to recognise the time value of money. Funds which are received today are worth more than those which will be received in the future by virtue of the fact that they may be invested in the meantime. Any valid method of investment appraisal must take this factor into account, and be capable of distinguishing between funds which are recovered rapidly, and those which flow back more slowly. In order to deal with this problem a variety of investment appraisal techniques have been developed which, in various ways, try to provide guidance on whether or not to invest in a particular project and in choosing between alternative projects. Amongst these methods are a group of techniques which make use of discounting procedures. The chapter begins, therefore, with a discussion of the time value of money and an outline of the methods available for taking it into account.