Question

Your broker called earlier today and offered you the opportunity to invest in a security. As a friend, he suggested that you compare the current, or present value, cost of the security and the discounted value of its expected future cash flows before deciding whether or not to invest. The decision rule that should be used to decide whether or not to invest should be:

Answer 1

The decision rule that should be used to decide whether or not to invest should be

Everything else being equal, you should invest if the discounted value of the security's expected future cash flows is greater than or equal to the current cost of the security.

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Explanation:

An investor would prefer to invest in a security that is expected to provide positive returns/cash flows in the near future. In order to take a decision with respect to a particular investment, the investor can discount the estimated future cash flows associated with the security (with the use of appropriate discount rate) and compare it with the current cost of security. If the discounted value of such cash flows exceeds or equals the current cost of security, it would mean that the investor would be able to increase his/her overall wealth through investment in the particular security. This approach would also help the investor to reduce his/her risks associated with investments having discounted value of future cash flows less than the cost of security (which would indicate negative returns or decrease in wealth).