Dixit and Pindyck state that most
investment decisions share three characteristics
1.
The degree of irreversibility. The initial
cost of the investment is at least partially sunk. You cannot recover all that
you put in should you immediately change your mind. For example, most
investments in marketing and advertising are firm specific and cannot be
recovered. Hence they are clearly sunk costs. A steel plant, on the other hand,
is industry specific-it can only be used to produce steel. One might think that
because in principle the plant could be sold to another steel company, the
investment expenditure is recoverable and is not a sunk cost. This is
incorrect. If the industry is reasonably competitive, the value of the plant
will be about the same for all firms in the industry, so there would be little
to gain from selling it. For example, if the price of steel falls so that a
plant turns out, ex post, to have been a "bad" investment for the
firm that built it, it will also be viewed as a bad investment by other steel
companies, and the ability to sell the plant will not be worth much. As a
result, an investment in a steel plant (or any other industry-specific capital)
should be viewed as largely a sunk cost.
2.
Uncertainty over the future. While it may be
very simple to predict how stock markets or even the world at large will look
like tomorrow, it is nigh impossible to accurately state what either of these
will be in 40 years from now. The best one can do is to assess the probabilities of the alternative outcomes
that can me greater or smaller profit for your venture.
3.
Flexibility over timing. One usually has some
leeway over the timing of the decision to invest. One can postpone action in
order to get more information about the future.
Bolton also states that the funding cost of the investment is an
important characteristic which must be taken into account.
There are various competing theories as to the exact purpose of
finance.
1.
Transfer of Savings to would be investors,
thus creating economic growth. This is essentially what banks do
2.
Finance exists to distribute risk and rewrds
3.
The markets can collectively master risk, and
this allows them to control the future path of returns
4.
Finance exists as a tool of social repression,
in order to maintain the status quo. It allows the rich to become more wealthy
while the poor become ever more indebted.
5.
Finance is a tool for speculation
Hayek stated that the problem of a rational economic order is
determined precisely by the fact that the knowledge of the circumstances of
which we must make use never exists in concentrated or integrated form, but
solely as the dispersed bits of incomplete and frequently contradictory
knowledge which all the separate individuals possess.
The financial system is made up of three key components; Assets,
liabilities and Equities. Assets are anything of value which you control.
Liabilities are debts which you owe. Equity is the portion of assets that you
own which are free from liability. These can be divided further between long
term and short term assets and liabilities and also shareholder equities, which
is the investment from shareholders and is permanent.
Banks take in savings from their customers or investors, and uses
this capital to loan to others and to fund investments. However, they keep a
portion in reserve in case of a demand for withdrawals. The ratio between the
money the bank has lent out and the portion it has kept in reserve is known as its
leverage. Perhaps a better, and more universal way of describing it however, is
to say that it is a frims assets to equities ratio. Increased leverage implies increased
fragility. A ‘good’ leverage ratio is seen as in or around 5:1, although at the
height of the financial crisis, many financial institutions were leveraged as
high as 40:1.
In order for a financial system to work, it must have a way of valuing
these various assets, liabilities and equities.
1.
Intrinsic valuation, relates the value of an
asset to the present value of expected future cashflows on that asset.
2.
Relative valuation, estimates the value of an
asset by looking at the pricing of 'comparable' assets relative to a common
variable like earnings, cashflows, book value or sales.
3.
Contingent claim valuation, uses option
pricing models to measure the value of assets that share option characteristics
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