What is an investment?
We shall study investments. So, what is it?
But it is useful to see investments in general from a higher viewpoint.
Therefore time plays a fundamental role.
and suppose the firm decides to invest a sum M in machinery, today, in order to reduce the future cash outlays.
Suppose the cash reductions will be ΔS1, ΔS2, ΔS3.
Then the investment can be represented as this:
(Note that cash flow analyses are always done with cash figures. We don't consider amortizations, which are not cash outlays.)
We shall study under which conditions this is a good investment, and under which ones it is bad.
We shall be more sophisticated than just saying: "Well, after year 2, the investment has already paid back for itself". Such a method of evaluation is called the "payback method" of analyzing investments. Though it is not devoid of usefulness, it is too crude, for reasons that will become clear in this finance course.
Rather, for each of the three future cash flows we shall compute its present value (PV) - it will require extra information about the investment and its environment - and we shall then be able to compute the NPV of the investment.
today you exchange your 1000€ for a promise
this promise (which is a contract) stipulates that you will receive 50€/year over the next 6 years, and the sixth year you'll also get back 1000€.
So the investment, for you, can be represented as this
There again, we shall study under which conditions (quality of the borrower, economic environment) this is an acceptable investment.
The contract in this example is called a "bond", because the borrower becomes tied by its promise. And this is the simplest type of bond, sometimes called "plain vanilla". Here it is a 6 year 5% bond.
More generally, promises like that are called "financial securities".
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