In the earlier units, you have learnt about the financial environment as well as financial securities, markets and valuation models while knowing about the corporate finance. Now, you need to have the clarity about how to take investment decisions and also the proper capital budgeting in achievement of our goals.
You are aware that any investor has to take decision about the investment, as own funds are involved in the investment. So, you can take investment decision only after analyzing entire process of investment that starts with funds contribution and ends with getting expectations fulfilled. In the sense, you will take decision only after ensuring that the required expectations in terms of returns are ensured at any cost. You are yet to decide whether to invest or not, whenever, you have faced with new investments and projects, though earlier units has lead to take decision.
In this lesson, the investment decision rules allow you to formalize the process and specify what condition or conditions need to be met to accept the project. For example, an investment decision rule may specify that only projects that the amount invested in them, in less than five years will be accepted or only projects that earn a return on capital greater that their cost of capital are good projects.
The characteristics of good investment decision rules are: –
1. It should maintain a fair balance between allowing manager to analyze the project and bring-in subjective assessment into the decision and ensuring that different projects and judged consistently.
2. It must maximize the value of the firm
3. It should work across a variety of investments.
So, an investment decision rule should lead to different conclusions on whether the project should be accepted or rejected. Main rule can be made as primary rule.
Category of Investment Decision Rule
The investment decision rule can be categorized in to two broad ways based on the basis of calculation of return: –
• Accounting Income-based decision rule
• Cash flow-based decision rule.
Accounting Income-based decision rule:
It is the oldest and most established investment decision rules. Here, accounting statements in particular accounting measures of income has been used. I.e., return on capital and return on equity.
Cash flow-based decision rule
This is nothing but the cash flow return on capital & equity. One simple modification to the accounting return on capital and equity is to use the cash earnings to compute these returns rather than the accounting earnings. Adding non-cash accounting expenses to operating earnings yields cash operating earnings.