Investment evaluation criteria

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Three steps are involved in the evaluation of an investment:

• Estimation of cash flows

• Estimation of the required rate of return (capital casting)

• Application of a decision rule for decision rule to make the choice

Investment decision rule

Investment decision rules can be called capital budgeting techniques or investment criteria. A sound valuation technique must be used to measure the economic value of an investment project. The essential property of a good technique is that it must maximize shareholder wealth. The following other characteristics should also be possessed by a strong investment endpoint:

• It must consider all cash flows to determine the true profitability of the project then.

• It should provide an objective and unambiguous way of separating good projects from bad projects.

• It should help to rank projects according to their true profitability.

• It should recognize that larger cash flows are better than smaller ones and that early cash flows are better than later cash flows.

• It should help choose among mutually exclusive projects the one that maximizes shareholder wealth.

• This should be a criterion applicable to any conceivable investment project independently of others.

These conditions will be clarified as we discuss the characteristics of the different investment criteria in the following articles.

Investment evaluation criteria

A number of investment appraisal criteria or capital budgeting techniques are commonly used. They can be grouped into the following two categories:

1. Discounted cash flow criteria

• Actual net value

• Internal rate of return

• Profitability index (PI)

2. Undiscounted cash flow criteria

• Recovery period

• Accounting rate of return

• Reduced recovery time

Discounted repayment is a variant of the repayment method. This is an up-to-date method, but it is not a true measure of the return on investment. We will show in our following articles that the net present value criterion is the most valid technique for evaluating an investment project. It is consistent with the objective of maximizing shareholder wealth.



Source by Randika Lalith Abeysinghe

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