There are three steps involved in evaluating an investment:
• Estimation of cash flows
• Estimation of the required rate of return (the capital list)
• Application of a decision rule to the decision rule to make the decision.
Investment decision rule
Investment decision rules can be called capital budgeting techniques or investment criteria. A sound evaluation technique should be used to measure the economic value of an investment project. The essential property of sound technique is that it must maximize shareholder wealth. The following other characteristics should also possess sound investment evaluation criteria:
• You must consider all cash flows to determine the true profitability of the project.
• It must provide an objective and unambiguous way to separate the good projects from the bad ones.
• It should help to classify projects according to their true profitability.
• You should recognize the fact that larger 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 that maximizes the wealth of the shareholders.
• It should be a criterion applicable to any conceivable investment project independent of others.
These conditions will become clearer as we discuss the characteristics of various investment criteria in the following publications.
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 criteria
• Recovery period
• Accounting rate of return
• Discounted amortization period
The discounted refund is a variation of the refund method. This is a discount method, but it is not a true measure of return on investment. We will show in our next 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.