Investing in Assets: Theory of Investment Decision-Making

Capital budgeting, or investment decision, depends heavily on forecasts of the cash and a correct calculation of the firm’s cost of capital. Given the cost of capital, that is, the appropriate discount rate and a reasonable forecast of the inflows, the determination of a worthwhile capital investment is straightforward. An investment is desirable when the present value of the estimated net inflow of benefits (or net cash inflow for pure financial investments) over time, discounted at the cost of capital, exceeds or equals the initial outlay on the project. If the project’s present value of expected cash flow meets these criteria, it is potentially “profitable” or economically desirable; its yield equals or exceeds the appropriate discount rate. On a formal level, it does not appear too difficult to carry out the theoretical criteria. The stream of the forecasted net future cash flows must be quantified; each year’s return must be discounted to obtain its present value. The sum of the present values is compared to the total investment outlay on the project; if the sum of the present values exceeds this outlay, the project should be accepted.