INVESTMENT DECISIONS

Corporate investment decisions often involve substantial amounts of money. Many investment decisions are also difficult to reverse and can affect the company's business far into the future. For example, in 1966 Boeing Company, an airplane manufacturer, decided to invest about $1 billion to develop the 747 jumbo jet. This investment delivered long-term benefits as the company was still selling the jets 30 years later. It was also able to take advantage of its experience with the 747 to develop new kinds of aircraft.
A business regards an investment as successful if it increases the wealth of the shareholders who own the company. This is accomplished when the firm earns profits and passes them back to the shareholders either in the form of dividends or as increases in the value or price of the stock. Dividends are a share of profits paid to shareholders as cash or as additional shares of stock. Profits or earnings that are not distributed to shareholders stay with the firm and are called retained earnings. These earnings influence the value of the stock because they increase the total asset value, or total amount of assets, of the firm. Because the value of their company's possessions has increased, the shareholders own stock that is worth more. If the firm realizes retained earnings of $1 per common share, it will add $1 to the value of each share. However, since many forces influence stock prices, the actual price of the stock will probably fluctuate and be more or less than the additional $1 per share.
Investment decisions—that is, deciding what projects to invest in—are based on two criteria: the expected rate of return and the risk or uncertainty of achieving the expected rate of return. The project's rate of return, or simply its return, is a measurement of its profit. A financial manager estimates the return based on forecasts of potential sales, expenses, and profits that might occur from an investment. For example, a company might have an opportunity to invest in a project that costs $100 million. If the project is expected to produce a profit of $10 million, this equals a rate of return of 10 percent on the investment of $100 million.
Before evaluating the rate of return, a financial manager must also consider the return's risk. The manager must consider the chances of earning or losing money on the project and how great the profits or losses could be. For example, if the company has a 90 percent chance of earning the $10 million return, the risk is rather small. On the other hand, if the company has only a 5 percent chance of earning the $10 million return, the project is very risky. Expected rates of return are higher with risky projects because they must compensate for the project's uncertainty to attract investors. Although their returns are not guaranteed, higher risk projects have a potential for greater profit.
Whether or not the company should go ahead with the project depends on what the $100 million could earn if invested differently. The company should accept any project that is expected to earn a higher return than shareholders can earn with another investment. For example, the shareholders could invest their $100 million by buying real estate. If the shareholders could earn a 20 percent return on their real estate investment, they are giving up that opportunity to invest in the company. In other words, 20 percent is the cost of investing their capital in the project, or the cost of capital. The firm should only accept projects whose expected return exceeds the shareholder's cost of capital.
In addition to investing in projects, firms also buy and sell entire businesses. Sometimes this takes place with a mutual agreement to merge or combine two companies into one. In other cases one firm, the buying firm, goes against the wishes of another firm's management, the target firm, and attempts a takeover. For example, a company can appeal directly to the target firm's shareholders by offering to buy their stock. If the buying firm acquires enough of the target firm's stock, it can control the target firm's activities.

Source : Microsoft ® Encarta ® 2006.