What is an investment decision rule

When faced with new investments and projects, firms have to decide whether to invest in them or not. While we have been leading up to this decision over the last few chapters, investment decision rules allow us to formalize the process and specify what condition or conditions need to be met for a project to be acceptable. While we will be looking at a variety of investment decision rules in this section, it is worth keeping in mind what characteristics we would like a good investment decision rule to have.

• First, a good investment decision rule has to maintain a fair balance between allowing a manager analyzing a project to bring in his or her subjective assessments into the decision, and ensuring that different projects are judged consistently. Thus, an investment decision rule that is too mechanical (by not allowing for subjective inputs) or too malleable (where managers can bend the rule to match their biases) is not a good rule.

• Second, a good investment decision rule will allow the firm to further our stated objective in corporate finance, which is to maximize the value of the firm. Projects that are acceptable, using the decision rule, should increase the value of the firm accepting them, while projects that do not meet the requirements would destroy value if the firm invested in them.

• Third, a good investment decision rule should work across a variety of investments. Investments can be revenue-generating investments (such as the Home Depot opening a new store) or they can be cost saving investments (as would be the case if Boeing adopted a new system to manage inventory). Some projects have large up-front costs (as is the case with the Boeing Super Jumbo), while other projects may have costs spread out across time. A good investment rule will provide an answer on all of these different kinds of investments. Does there have to be only one investment decision rule? While many firms analyze projects using a number of different investment decision rules, one rule has to dominate. In other words, when the investment decision rules lead to different conclusions on whether the project should be accepted or rejected, one decision rule has to be the tiebreaker and can be viewed as the primary rule.

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Lessons From The Intelligent Investor

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Responses

  • teodros
    What is characteristics of good investment decision rule?
    8 years ago
  • Rowan
    What is an investment decision rule finance analysis?
    8 years ago

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