Three steps are involved in evaluating an investment:

• Estimation of cash flows

• Estimation of the required rate of return (the capital distribution)

• Application of a decision rule to the decision rule to make the choice

Investment decision rule

Investment decision rules may be called capital budgeting techniques or investment criteria. A sound technical evaluation must be used to measure the economic value of an investment project. The essential property of a good technique is that it should maximize shareholder wealth. The following other characteristics must also be possessed by 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 good projects from bad projects.

• It should help classify projects according to their true profitability.

• You must recognize the fact that larger cash flows are preferable to smaller ones and early cash flows are preferable to later ones.

• It should help choose among mutually exclusive projects that project that maximizes shareholder wealth.

• It must be a criterion applicable to any conceivable investment project independently of others.

These conditions will become clearer as we discuss the characteristics of various investment criteria in the following posts.

Investment evaluation criteria

In practice, various investment evaluation criteria or capital budgeting techniques are used. 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 criterion

• Recovery period

• Accounting rate of return

• Discounted amortization period

Discounted rebate is a variation of the rebate method. It implies the discount method, but it is not a true measure of the 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.