management Back Forwards
Accounting: Investment Decision-Making (Long-Term)
 

Discounting Techniques

The techniques based on financial theory (discounting techniques) link investment decisions to their directly associated financing decisions - a decision to commit money to an investment inevitably means you must ultimately obtain the money needed for that investment from external investors (financial institutions or shareholders). Managers are, in effect, agents for these external investors and must seek to find investments within the company that promise to offer a financial return that is greater than the financial returns available to external investors elsewhere in order to attract funding. The market return expected by external investors, which is equivalent to the cost of capital to the company, is determined by the availability of alternative investment opportunities.

 

For example, if the company wishes to obtain finance for the above investment by raising a bank loan, it must offer the bank an interest rate which is at least as good as any alternative investment that is available to the bank.

The Time Value of Money

Where money is invested in long-term projects it is therefore important to take account of the important opportunity cost associated with the commitment of funds to a project. There will always be alternative uses for money (either within the company or elsewhere) which will offer a financial return, so the use of funds will always have an opportunity cost associated with it. This opportunity cost is the basis for what is termed "the time value of money" i.e., that there is a rational preference to receive money earlier than later.