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Financial Management - Capital Budgeting – A Conceptual Framework

Investment Evaluation Criteria - Evaluation Of Capital Projects

   Posted On :  19.06.2018 11:10 pm

The capital budgeting process begins with assembling of investment proposals of different departments of a firm.

Investment Evaluation Criteria
 
The capital budgeting process begins with assembling of investment proposals of different departments of a firm. The departmental head will have innumerable alternative projects available to meet his requirements. He has to select the best alternative from among the conflicting proposals. This selection is made after estimating return on the projects and comparing the same with the cost of capital. Investment proposal which gives the highest net marginal return will be chosen.
Following are the steps involved in the evaluation of an investment:

1. Estimation of cash flows

2. Estimation of the required rate of return

3. Application of a decision rule for making the choice


Features required by Investment Evaluation Criteria

 
A sound appraisal technique should be used to measure the economic worth of an investment project. Porter field, J.T.S. in his book, Investment Decisions and Capital Costs, has outlined some of the features that must be had by sound investment evaluation criteria.

1. It should consider all cash flows to determine the true profitability of the project.

2. It should provide for an objective and unambiguous way of separating good projects from bad projects.

3. It should help ranking of projects according to their true profitability.

4. It should recognise the fact that bigger cash flows are preferable to smaller ones and early cash flows are preferable to later ones.

5. It should help to choose among mutually exclusive projects that project which maximizes the shareholders’ wealth.

6. It should be a criterion which is applicable to any conceivable investment project independent of others.
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