The evaluation of the choice of financial investments

The problem faced by investment evaluation is, in essence, a problem of choice

by Lorenzo Ciotti
The evaluation of the choice of financial investments
© Spencer Platt / Staff Getty Images Sport

The problem faced by investment evaluation is, in essence, a problem of choice. In fact, every company or individual must make investment decisions aimed at allocating only those projects that create value, taking into account the limited resources available, such as production factors.

In order to systematically resolve this problem of choosing between possible alternatives, it is necessary to be able to discriminate the different possibilities on the basis of a unit of measurement which must be able to highlight both the validity of the initiative and the related economic and financial effects.

it is commonly accepted that the unit of measurement to refer to in this case is the economic value of the initiative.

The cost of an investment is given by the financial outflows, or smaller inflows, connected to its implementation; similarly, the benefits associated with it are made up of incoming financial flows, or lower outgoing flows, where future returns and costs are elements of a predictive nature.

In this way an investment operation can be represented by an estimated succession of future monetary inflows and outflows called cash flow. Another determining factor in the evaluation of investments is time: the relevance of the time factor depends on a financial effect that links it to the value of money and according to which, all other conditions being equal, to an extension of the return times of the invested resources in a project there corresponds to a reduction in financial benefits.

The evaluation of the choice of financial investments

Furthermore, the passage of time introduces a further level of uncertainty in the evaluation process since, as the reference intervals widen, the forecasts on the variables on which the results of the operation depend progressively tend to lose significance.

A further essential element of the evaluation process is the interest rate chosen as a reference. The interest rate at which the incoming and outgoing financial flows are discounted is called the opportunity cost of capital because it represents an alternative that is given up to undertake the particular investment project analyzed.

Other important elements to consider for the rational evaluation of the viability of an investment are the risk associated with the investment: the investor's risk appetite is one of the main variables in choosing the type of investment.

The trend forecasts (upward or downward) of the financial market in which you intend to invest. And also the periodicity of expected incoming and outgoing income flows.