Financial leverage in the case of an investment project with stochastic cash flow

Abstract

The management science examines the investment and financing as business actions what generate intertemporal input-output cash flows. The decisions about investment and financing are important long-run decisions based on the prediction how money borrowing and lending and created cash flow will influence the business processes. In order to make rational decisions investor applies wide spectrum of the quantitative analysis methods. Information and knowledge transform the preferences of investor and is an important tool for uncertainty and risk reduction. However, the analysis of literature (see, for example, [1], [2], [3], [4], [5], [6]) indicates that the criterion for accepting long-term investments is the most controversial issue in financial management. James C. Van Horne, John M. Vachowiz Jr. state "Criterion for accepting long-term investments is probably the most controversial and difficult issue in financial management." In this paper different attributes of the intertemporal cash flows generated by investment and financing programs which influence the investor's utility are investigated. A case of stochastic investment cash flows is considered. The main result is formulated as rule of credit contract selection: at a given amount of borrowed sum and given interest rate the contract with the largest interest enlarges the expected net present value of the created stochastic cash flow and reduces the probability that the net present value will become negative. The original concept of the credit contract scissors is introduced. The presentation of the material is illustrated with an example calculated using Microsoft Excel. The results of the present paper appear to be innovative, not discussed in literature available to the author of the present paper. The theoretical questions examined in this paper require further investigation.