Three steps are involved in evaluating an investment:
• Cash flow estimation
• Estimation of the required rate of return (the distribution of capital)
• Application of a decision rule to the decision rule to make the choice
Investment Decision Rule
Investment decision rules may be called capital budgeting techniques or investment criteria. A sound technical evaluation must be used to measure the economic value of an investment project. The essential property of a good technique is that it should maximize shareholder wealth. The following other characteristics must also be possessed by sound investment evaluation criteria:
• You must consider all cash flows to determine the true profitability of the project.
• It must provide an objective and unequivocal way of separating good projects from bad projects.
• It should help classify projects according to their true profitability.
• You must recognize the fact that larger cash flows are preferable to smaller ones and early cash flows are preferable to later ones.
• It should help choose among mutually exclusive projects that project that maximizes the wealth of the shareholders.
• It must be a criterion applicable to any conceivable investment project independently of others.
These conditions will become clearer as we discuss the characteristics of various investment criteria in subsequent posts.
Investment Evaluation Criteria
Various investment evaluation criteria or capital budgeting techniques are used in practice. They can be grouped into the following two categories:
1. Discounted Cash Flow Criteria
• Net present value
• Internal rate of return
• Profitability index (PI)
2. Undiscounted cash flow criterion
• Recovery period
• Accounting rate of return
• Discounted amortization period
The discounted refund is a variation of the refund method. It implies the discount method, but it is not a true measure of the return on investment. We will show in our following posts that the net present value criterion is the most valid technique to evaluate an investment project. It is consistent with the goal of maximizing shareholder wealth.