5.0 Introduction

You must make financial decisions throughout your professional career and everyday personal life. Some of these decisions are easy. To make the best choice you need a little intuition and simple calculation. Other decisions are very challenging, confronting you with a great array of competing options, each of which is bundled with numbers projected from now until … whenever. If you tried just to wing it in these latter scenarios, you could make a catastrophic mistake.

For example, suppose you are the production manager for a company that soon needs to replace a critical machine that is nearing the end of its useful life. At your invitation, salespeople from three competing companies have paid you a visit this week. Each of them showed you an impressive replacement machine. The three machines appear to be equal in design and performance, but each carries a different price tag. Each machine also differs widely in operating costs such as power consumption, consumables, and labour costs. The maintenance requirements also follow different timetables and have different costs. In all cases, you can either purchase the machines or lease them through the supplier’s leasing plan.

These machines are not cheap. Because the one you select represents such a significant investment on your company’s part, good financing for it is an integral part of the decision. Will the money to pay for it come from a bank loan, a bond issuance, or by issuing some common shares? Perhaps the finance department can withdraw some money from your organization’s current investments. Each of these funding sources is associated with a different interest rate.

Your company relies on you to choose the best machine at the lowest possible cost. From a strictly financial perspective, and assuming that all machines are equally productive, which of the three machines is your best choice?

This business investment decision should not be guesswork. In previous chapters you have already learned many of the fundamental financial skills required to make effective monetary decisions. In this chapter you will amalgamate and apply your existing skills in dealing with compound interest, ordinary annuities, annuities due, leases, loans, and much more. Using a concept known as cash flows, there are two different mechanisms you will learn about to help make these types of business investment decisions: net present value and internal rate of return. Each of these techniques allow you to analyze a decision-making scenario, determine if a particular project is profitable, and select the best option from several choices.

Attribution

“5.0 Introduction” from Financial Math – Math 1175 by Margaret Dancy is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License, except where otherwise noted.