The Only Investment Selection Criterion You Will Ever Need

Abstract

ABSTRACT The investment evaluation process is comprised of two components, namely screening and ranking of investment opportunities. Screening identifies those projects which meet or exceed a predetermined standard, whereas ranking places those projects in order of most desirable to least desirable. A screening criterion is necessary for every economic evaluation, to assure that only those investments will be made which will contribute to achieving the desired goals of the investing organization. Ranking criteria are only needed to allocate resources when they are in short supply. Selection of projects, from the investment opportunities being considered, in accordance with proper ranking criterion will yield the maximum return possible with the limited resources available. This paper will discuss the ratio of net present value to present value investment, commonly referred to as present value ratio, present value index or percent present value profit. It will be shown that this index can be used both as a screening and a ranking criterion, if it is based upon the proper opportunity cost of capital. It will always properly rank investment opportunities, when investment funds are the resource in short supply, provided that the effect of delaying a project is included in the analysis. Use of this criteria over a great number of years has proved its value. By simple examples it will be shown that this criterion is easily calculated from information already determined for most economic evaluations and that it will properly rank all types of investment opportunities, while other criteria frequently used in the Petroleum Industry will not. It will be specifically shown that internal rate of return and growth rate of return can be misleading when used as ranking criteria because of their inherent bias in favor of near term cash flows. Frequently, screening and ranking criteria are arbitrarily adjusted to compensate for ill defined and unquantified risk and uncertainty. This paper will discuss the proper procedure to account for risk and uncertainty in screening and ranking investment opportunities.