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making financial decisions;

The Investment Principle

            Firms have scarce resources that must be allocated among competing needs. The first and foremost function of corporate financial theory is to provide a framework for firms to make this decision wisely. Accordingly, we define investment decisions to include not only those that create revenues and profits (such as introducing a new product line or expanding into a new market) but also those that save money (such as building a new and more efficient distribution system). Furthermore, we argue that decisions about how much and what inventory to maintain and whether and how much credit to grant to customers that are traditionally categorized as working capital decisions, are ultimately investment decisions as well. At the other end of the spectrum, broad strategic decisions regarding which markets to enter and the acquisitions of other companies can also be considered investment decisions.         Corporate finance attempts to measure the return on a proposed investment decision and compare it to a minimum acceptable hurdle rate to decide whether the project is acceptable.  The hurdle rate has to be set higher for riskier projects and has to reflect the financing mix used, i.e., the owner�s funds (equity) or borrowed money (debt). In the discussion of risk and return, we begin this process by defining risk and developing a procedure for measuring risk. In risk and return models, we go about converting this risk measure into a hurdle rate, i.e., a minimum acceptable rate of return, both for entire businesses and for individual investments.

            Having established the hurdle rate, we turn our attention to measuring the returns on an investment. In analyzing projects, we evaluate three alternative ways of measuring returns—conventional accounting earnings, cash flows, and time-weighted cash flows (where we consider both how large the cash flows are and when they are anticipated to come in). In extensions of this analysis, we consider some of the potential side costs that might not be captured in any of these measures, including costs that may be created for existing investments by taking a new investment, and side benefits, such as options to enter new markets and to expand product lines that may be embedded in new investments, and synergies, especially when the new investment is the acquisition of another firm.