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Business Investment Decisions

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					Business Investment Decisions

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515

Summary:
There are many investments that a company can make. It is a financial
manager’s job to help the management team evaluate the investments, rank
them and suggest choices. This process is called capital budgeting.

Some investments, however, defy financial analysis; an example of this
may be seen in charitable donations, which provide intangible benefits
that financial mangers alone cannot evaluate.

It may be argued that investment decisions fall into one of three basic
dec...


Keywords:
Business investment,business decisions,business investment
decisions,business finance


Article Body:
There are many investments that a company can make. It is a financial
manager’s job to help the management team evaluate the investments, rank
them and suggest choices. This process is called capital budgeting.

Some investments, however, defy financial analysis; an example of this
may be seen in charitable donations, which provide intangible benefits
that financial mangers alone cannot evaluate.

It may be argued that investment decisions fall into one of three basic
decision categories:

Accept or reject a single investment proposal

Choose one competing investment over another

Capital rationing – with this particular category, the limited investment
pool is active deciding which projects among many should be chosen.

Whilst each corporation uses its own criteria to ration its limited
resources, the major tools are:

Payback period
Net present value

Payback period method – many companies believe that the best way to judge
investments is to calculate the amount of time it takes to recover their
investments.
Analysts can easily calculate paybacks and make simple acceptance or
reduction decisions based on a necessary payback period. Those projects
that come close to the mark are accepted, those falling short are
rejected. For example, the managers of a small company may believe that
all energy and labour saving devices should have a three-year payback and
that all new machinery must have an eight-year payback. Additionally,
research projects should pay back in ten years. Those requirements are
based on management’s judgements, experience, and level of risk.

By accepting projects with longer paybacks, management accepts more risk.
The further out an investment’s payback, the more uncertain and risky it
is. Payback criteria are desirable because they are easy to use,
calculate and understand; however they ignore the timing of cash flows
and accordingly the time value of money. Projects with vastly different
cash flows can have the same payback period.

Another disadvantage of using payback is that it ignores the cash flows
received after the payback.


Net present value methods

The same method used for valuing the cash flows of bonds and stocks is
also used to value projects. It is the most accurate and most correct
method. The further in the future a dollar is received the greater the
uncertainty that it will be received, referred to as risk, and the
greater the loss of opportunity to use those funds, referred to as
opportunity cost. Accordingly cash flows received in the future will be
discounted more steeply depending on the riskiness of the project.

The way a business wishes to fund itself are financing decisions
independent of investment decisions.

In my own experience, I have only ever used the payback method, along
with my fellow business colleagues, perhaps because this has always been
easier to understand and use and calculate. This served us well but
caused frequent conflicts between operations, marketing and finance, for
understandable reasons.

In summary, whereas most companies may continue to use the payback method
due to the aforementioned reasons, it is well worth noting that another
option is there and, especially for the financial side of the business,
gives a very interesting option.