(124)---INVESTMENT EVELUATION CRITERIA

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.