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The evaluation of an investment involves three steps:
* Calculation of cash flows
* Calculation of the required rate for return (the capital cast)
* Decision rule application for making the decision
Investment decision rule
These investment decision rules are also known as capital budgeting techniques or investment criteria. To assess the economic value of an investment project, it is important to use a sound appraisal technique. A sound technique should maximize shareholders wealth. This is the essential property. A sound investment evaluation criteria should also possess the following characteristics:
* The true profitability of a project should be determined by analyzing all cash flows.
* It should be able to clearly and objectively distinguish between good and bad projects.
It will help to rank projects according their true profitability.
It should also recognize that cash flows larger than smaller are better and cash flows earlier are better than later.
* It should be able to help choose between mutually exclusive projects the project that maximizes shareholders wealth.
It should be an independent criterion that can be applied to all possible investment projects.
These conditions will be clarified when we discuss the features and investment criteria in the next posts.
Investment Appraisal Criteria
There are many investment budgeting and appraisal techniques that can be used in practice. These can be divided into the following categories:
1. Cash flow discounts
* Net present value
* Internal rate for return
* Profitability index (PI).
2. Cash flow is not to be discounted
* Period of payback
* Accounting rate of Return
* Reduced payback period
A variation on the payback method is discounted payback. Although it uses a discounted method, it does not measure investment profitability. In the following posts, we will demonstrate that the net present value criteria is the best method of evaluating investment projects. This is in line with the goal of maximising shareholders wealth.
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