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Rules to be followed while making Investment Decisions
Usually, the investment decision rules are known as capital budgeting decisions or investment criteria. To determine the financial worth of an investment project, sound capital budgeting rules should be followed.
The most important property of a good capital budgeting technique is that it should maximize shareholders’ wealth. However, there are some other rules too that must be followed for making an investment decision. These include the following −
An investment decision should address all cash flows to determine the correct profitability of a project. This should include all cash inflows and cash outflows. Usually, the calculation of cash flows is a necessary rule because it contains cash that is central to the success of an investment.
There should be an unambiguous and easy way of separating good projects from bad ones. In fact, no one wants to invest in projects that do not have a good return or those that are considered bad in terms of long-term profitability. That is why, it is necessary to separate good investments that have the potential to maximize shareholders’ wealth.
There should be a way to rank projects according to their true profitability. It is important because the primary aim of all investments is to generate profits. If an investment in a project is not going to generate profit, there is hardly any reason to invest money in that project. Also, profitability in the long term should be considered because the existence and growth of a company are related to long-term profitability.
There should be a priority to bigger cash flows and earlier payments. In fact, bigger cash flows let the investors have faster returns because large chunks of investments are returned at once. Getting the cash earlier is good due to the time value of money which states that the value of a certain amount is more in present than its value in the future.
The investment decision rules must help to choose the better project when there are mutually exclusive investments in the horizon. This is again due to the process of maximizing shareholders’ wealth. Moreover, choosing a good project among similar ones is also good for the long-term profitability of the investments.
In selecting the investments according to investment decision rules, it should have a criterion that is applicable to any conceivable investment project that is independent of the influence of the others. Individuality is important because without it, choosing the right option would be impossible, and the managers will focus on the wrong investment projects that can lead to large losses.
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