Friday, January 15, 2010


Investment Evaluation Criteria

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.

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