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Investment Evaluation

Three steps are involved in the evaluation of an investment: Investment evaluation is involved by the estimation of cash flows and the required rate of return (the opportunity cost of capital). It is also depending on the Application of a decision rule for making the choice. Thus, it is confined to the third step. Specifically, we focus on the merits and demerits of various decision rules.

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 it 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 the project and provide for an objective and unambiguous way of separating good projects form bad projects. It should help ranking of projects according to their true profitability and should recognize the fact that bigger cash flows true profitability. Bigger cash flows are preferable to smaller once and early cash flows are preferable to later ones. It should help top choose among mutually exclusive projects that project which maximizes the shareholders’ wealth, which is applicable to any conceivable investment project independent of other.

Evaluation criteria

A number of investments criteria (or capital budgeting techniques) are in use in proactive. They may be grouped in the following two categories:

1. Discounted cash flow (DCF) criteria

(i) Net present value (NPV)

(ii) Internal rate of return (IIR)

(iii) Profitability index (PI)

2. Non-discounted cash flow criteria

(i) Payback period (PB)

(ii) Discounted payback period

(iii) Accounting rate of return (ARR).

Discounted payback is a variation of the payback method. It involves discounted cash flows, but as we shall see later, it is not a true measure of investment profitability. We will show in the following pages that the net present value criterion is the most valid technique of maximizing the shareholders wealth.