The three financial decisions every firm makes
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Investment Decisions
The investment decision — also called capital budgeting — is about choosing which long-term assets and projects to commit capital to. This is the most consequential decision: it determines the company's future cash flows and ultimately its value.
The guiding principle: invest only in projects that are expected to create value for shareholders — that is, where the return exceeds the cost of the capital deployed.
Key tools used to evaluate investment decisions: - NPV (Net Present Value): accept if NPV > 0. - IRR (Internal Rate of Return): accept if IRR > cost of capital. - Payback period: recover the investment within an acceptable timeframe.
Investment decisions affect the left side of the balance sheet — they determine what assets the firm holds and what cash flows those assets generate. All other decisions are secondary to getting this right.
Worked example
A manufacturer is deciding between two projects: Project A (new production line, NPV +€400,000) and Project B (office refurbishment, NPV +€20,000). Both create value, but with limited capital the investment decision means prioritising A. Projects with negative NPV — say, a marketing campaign expected to lose money — should be rejected even if they seem strategically attractive.
Exam strategy
DCF questions turn on the discount rate — higher risk = higher rate = lower NPV. IRR and NPV agree on accept/reject but can rank projects differently.
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