MANECON - Chapter 5 Investment Decisions (copy)

Investment decisions

involve a tradeoff between current sacrifice and future gain

Discounting

to determine whether the investment is profitable

Discounting

focuses on the present value of money by considering the current worth of future cash flows

Compounding

opposite of discounting

Compounding

emphasizes the future value of money by accounting for the growth of investments over time

Rule of 72

an easy way to calculate how long an investment will take to double in value given a fixed annual rate of interest.

NPV Rule

Discount + future benefits and compare with the current cost of the investment If difference is positive, investment earns more than cost of capital

Internal rate of return (IRR)

close cousin of NPV analysis

Internal rate of return (IRR)

is the discount rate that sets NPV equal to zero

NPV analysis

is the correct way to evaluate investment decisions

positive NPV

is both necessary and a sufficient condition for an investment to be profitable

Break-Even Analysis

Can give you the wrong answer as it ignores the time value of money.

Break-Even Analysis

Easy to do and generates simple, intuitive answers

Break-Even Quantity

quantity that will lead to zero profit

Pricing and production

extent decisions that require marginal analysis, not break-even analysis

Shut down decisions

work with break-even prices rather than quantities

Break-Even Price

average avoidable cost per unit

Specific Investment

one that is sunk or lacks value outside of a trading relationship

Trading Relationship

the party can be held up by its trading partner

Contracts

should encourage both investment and trade

Long-term contracts

induce higher levels of relationship-specific investments