What are the three important steps in the evaluation of investments?

The following three important steps are involved in evaluating an investment decision −

  • Estimation of Cash Flow

  • Estimation of Internal Rate of Return (the Opportunity Cost of Capital)

  • Application of a decision rule for making the choice

Let us take a closer look at each of these steps.

Estimation of Cash Flow

Discounted Cash Flow (DCF) techniques address the time value of money as well as the opportunity costs, which is the cost of foregoing investment in a project for selecting another in its place. The major types of DCF include Net Present Value (NPV), Internal Rate of Return (IRR), and Profitability Index.

  • NPV is the gap between the present value of cash inflows of an investment and its present value of cash outflows. To determine the cash flows, a market-based discount rate is used.

  • Internal rate of return (IRR) is the rate the investment will generate in its useful lifetime. IRR pushes NPV to zero value.

  • The profitability index (PI) is the ratio of net inflows to net outflows of an investment. An investment is adopted when PI is greater than 1 and rejected when the PI is less than 1.

Non-discounted Cash Flows (NDCF) does not consider the time value of money and takes the dollar value of an investment constant over time. The payback period (PBP) is the sole non-DCF method that uses cash flow estimations.

Estimation of Internal Rate of Return (the Opportunity Cost of Capital)

The opportunity cost of capital is the cost involved in taking up a certain capital project instead of another. The cost of the latter is usually foregone when the former is selected. Therefore, the cost of the second project is the cost of capital. It is also called "opportunity cost of capital", as the capital decisions come as an opportunity, and when the second most appealing opportunity is foregone, it is called opportunity cost of capital.

Determining the opportunity cost of capital is important in evaluating an investment criterion. This offers insight into the profitability and long-term gain of a project when calculated generally.

Application of a decision rule for making the choice

Capital budgeting techniques and investment criteria are related to the application of the decision rule for making a sound choice of evaluation of an investment. The other rules that should be included are −

  • It should consider all cash flows to determine true profitability.

  • There should be a way to determine unambiguous projects and to separate good projects from bad ones.

  • There should be a way to rank projects according to the true profitability.

  • It should realize that bigger and sooner cash flows are better than smaller and later cash flows respectively.

  • If the investments are mutually exclusive, it should provide information about the more profitable ones.

  • There should be a criterion that helps in choosing a conceivable investment project that is independent of others.

Updated on: 27-Oct-2021

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