The idea that investment decisions are essentially options applies to all kinds of personal decisions. Rather than valuing oil reserves at current prices, companies can purchase them and develop them in a future timeframe, when prices are high and low. This option-based approach makes it possible to understand investment decisions without worrying about monetary value. In addition, presenting examples “closer to home” will help individuals grasp the underlying concepts more readily.
Capital investment decisions are usually made to generate new profit opportunities. These investments may include research and development, new plants or technologies, marketing expenditures, and more. Sometimes, companies invest to exit money-losing operations and extract themselves from contractual obligations. One example is severance pay for employees. Other investments may be in reducing future costs. If a company can invest in R&D and then recoup some of its initial outlay, it will make the investment worthwhile.
Investment decisions are an important part of financial management. A prudent investor should know their current financial situation and how much risk they are willing to accept. Next, they should decide what type of investments are best suited to their risk profile and investment objective. Next, they should choose an asset allocation, which is the allocation of financial resources. This decision may be made in stock investments, debentures, bonds, real estate, options, and commodities. A particular investment may be chosen based on a company’s long-term business plans and objectives. A short-term investment may be appropriate if the manager overseeing business operations is more interested in generating short-term returns.
The NPV rule is a useful tool for understanding the thought process of managers. It is a formula that requires the user to compute the expected stream of profits and costs and then select the appropriate discount rate. There is little consensus as to how to calculate the profits stream, but most managers use a common strategy – seeking consensus projections with the use of a medium-high-low range of estimates. This approach is based on a faulty model and will not give an accurate picture of future profits.
The ability to delay irreversible investment expenditures changes the model. The ability to delay investment expenditures can affect the decision to invest. This complicates the net present value (NPV) rule. Managers should use richer frameworks that can address these issues more directly. It is important to note that an investment decision is never a simple one. Even if it is based on a mathematical model, it can be changed based on various factors, such as the ability to delay the investment.
Many corporate decisions follow NPV analysis. During a time when prices are dropping drastically, many industries can absorb huge operating losses without any significant disinvestment. When prices are rising, investors are generally more optimistic about future profits, while during a period of market decline, they become extremely pessimistic. This causes investors to over or under-react to market events. But, when prices are falling, investors are forced to make tough decisions.