Three steps are involved in the evaluation of an investment:
• Estimation of cash flows
• Estimation of the required rate of return (the cast of capital)
• Application of a decision rule for decision rule for making the choice
Investment decision rule
The investment decision rules may be referred to as capital budgeting techniques, or investment criteria. A sound appraisal technique should be used to measure the economic worth of an investment project. The essential property of a sound technique is that is should maximize the shareholders wealth. The following other characteristics should also be possessed by a sound investment evaluation criterion:
• It should consider all cash flows to determine the true profitability of then project.
• It should provide for an objective and unambiguous way of separate good projects from bad projects.
• It should help ranking of projects according to their true profitability.
• It should recognize the fact that bigger cash flows are preferable to smaller ones and early cash flows are preferable to later ones.
• It should help to choose among mutually exclusive projects that project which maximizes the shareholders wealth.
• It should be a criterion which is applicable to any conceivable investment project independent of others.
These conditions will be clarified as we discuss the features of various investment criteria in the following posts.
Investment Appraisal Criteria
A number of investment appraisal criteria or capital budgeting techniques are in use of practice. They may be grouped in the following two categories:
1. Discounted cash flow criteria
• Net present value
• Internal rate of return
• Profitability index (PI)
2. Not discounted cash flow criteria
• Payback period
• Accounting rate of return
• Discounted payback period
Discounted payback is a variation of the payback method. It involves discounted method, but it is not a true measure of investment profitability. We will show in our following posts the net present value criterion is the most valid technique of evaluating an investment project. It is consistent with the objective of maximizing the shareholders wealth.
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