Evaluation of the effectiveness of investment projects

 

 

The investment policy is based on an accurate calculation of the expected results of investing money, since this directly affects the financial condition and activities of the enterprise. Evaluation of the effectiveness of investment projects includes a number of indicators that together give a detailed picture of the prospects of the initiative. Consider the main criteria and methods for evaluating investment projects.

How projects are evaluated

Any investment in any undertaking goes through several mandatory stages:

• making a decision on financing, while determining the objectives of the undertaking and the directions of funding;
• the actual financing of the processes of the per-approved plan;
• the stage of payback and reaching the expected rate of return, achieving the set goals, making a profit.
• Investing money in an investment undertaking involves not only making a profit, but also achieving the goals set by a businessman (or several partners) in his own interests. Assessing the effectiveness of the investment project will help the entrepreneur or financier to understand whether he will lose his money as a result of investments, and whether the expected profit is able to compensate him for the rejection of other possible investment options.

Conducting an assessment of the effectiveness of an investment project can take from several days to several years, depending on the scale and complexity of the undertaking.


It is advisable to carry it out not only when determining the potential of the proposal, but also for an informed choice between several competitive options, as well as for ranking and establishing a priority plan for the implementation of several initiatives depending on the expected economic effect.



The basic principles for assessing the effectiveness of investment projects in accordance with the Methodological Recommendations of the Russian Academy of Sciences are as follows:

• evaluation and analysis is carried out throughout the entire calculation period, i.e. the existence of the initiative;
• cash flows (outflows and inflows) are also modeled for the full life cycle of the undertaking;
• when comparing several initiatives, they are given in comparable conditions for the objectivity of the result;
• the effect of the project implementation should be positive (when considering one proposal) and as positive as possible (with a multivariate choice);
• the time factor is taken into account (possible changes in the initially laid down parameters, gaps between the payment and the receipt of components or raw materials, etc.);
• only upcoming costs and revenues are taken into account, resources created earlier are not included in costs, since their opportunity cost is estimated;
• all possible consequences of the undertaking (economic, environmental, social, etc.) are calculated;
• the composition of the participants, the possible discrepancy of their business interests, the different assessment of the cost of capital, calculated according to the personally established discount rate, are taken into account;
• accounting for inflationary processes and possible risks;
• multi-stage process, at each stage the initiative is evaluated anew, more deeply, while taking into account new parameters.

At the same time, we should not forget about the orientation of each specific initiative to a specific goal. If the proposal deals with infrastructure development (construction of bridges, roads, bicycle parking) or any social issues (education, sports, health), then the methods of economic analysis are most often unacceptable. The level of effectiveness of such initiatives can be considered an improvement in the quality of life of citizens, while making a profit is secondary or not considered at all.

What methods are used to evaluate investment projects?

Among the whole variety of indicators, the following main complementary criteria for assessing the effectiveness of investment projects are distinguished:

• economic, showing the ability of the undertaking to preserve the value of previously invested funds in the process of implementation;
• financial, focusing on solvency and liquidity indicators.

In international practice, different methods of assessing the economic efficiency of investment projects are used. They can all be divided into two groups:

• Static. They are simple and minimally laborious. Their main feature is the possibility of admitting equal expenses and incomes in the calculations throughout the entire period of the initiative. In addition, the temporal dynamics of the value of money is not taken into account here.
• Dynamic. They are able to provide the investor with more accurate and detailed data, but in unstable markets, they require regular modification. In dynamic methods, the most important factor is the discounting of the value of money, but in order to avoid errors, the discount rate should be accurately calculated.

In order to reduce the likelihood of error and adequately assess the feasibility of investment, a combination of these methods is usually used.

Static Assessment Methods

Static (simplified) methods for assessing the effectiveness of investment projects have been widely used since the times when discounting was not yet recognized as one of the most accurate methods of analysis. They are acceptable for small investments for a short-term period (less than a year), and are also necessary for obtaining additional information. Let's take a closer look at them.

The payback period is simple. This implies the time from the beginning of the implementation of the idea to the onset of the payback period. The beginning is, as a rule, the start of operating activities, and the payback period is the earliest point at which net cash receipts become non-negative and remain so in the future.

The calculation consists in determining the period of time for which the amount of cash inflows will cumulatively become equal to the volume of initial investments.

Simple payback period

where is:

• PP – payback period in years;
• TOabout – the initial invested amount of money;
• CFcg – the average annual amount of revenues from the implementation of the initiative.
• This method of assessment allows you to understand whether it will be possible to reimburse the costs for the life cycle of the undertaking.

Suppose that 1 million rubles were initially invested in a project with a total duration of 10 years, an average of 150 thousand rubles will be returned annually. Applying the formula, we find a solution:

PP = 1000000 / 150000 = 6.66 years.

Therefore, the payback period will come in 6 years and 7 months, after which you can expect a profit.

The modified formula looks a little more accurate:

Modified formula

where the initial investment is divided by the net annual profit of the PCs.g. (i.e. after deduction of taxes, but without depreciation).


If in our example the net profit will be 50 thousand rubles, then we will get the following picture:

PP = 1000000 / 50000 = 20 years.


Thus, only in 20 years the net profit will be equal to the amount of the down payment.


The problem is that in addition to the return of money, the investor expects a profit. In our example, there are prerequisites for obtaining it, although discounting is not taken into account here. If the average income per year will be 100 thousand rubles, then the payback period will coincide with the end of the life cycle, therefore, the entrepreneur will suffer losses, since he could earn by investing this money in an alternative idea. Also, with annual inflows that increase or decrease in the process of project implementation, it is impossible to make a correct calculation in a simple way. In addition, the one-time investment of capital is mandatory.


The estimated rate of return (ARR). This methodology for assessing the effectiveness of investment projects characterizes the return on investment and has the form of a ratio of money receipts relative to the start-up fee. Calculated as a percentage.

Rate of Profit Formula

where is:

CFC.g. – average annual income from the main activity;
Co is a start-up investment.


In relation to our example, this indicator of evaluation of an investment undertaking has the following value:

ARR = 150000 / 1000000 = 0,15 * 100% = 15%.

This indicator indicates that with a start-up investment of 1 million rubles, the rate of return should be 15% to receive the desired annual income.


There are varieties of this formula, where the numerator uses the values of net annual profit (after tax payments) or gross average annual profit (before interest and taxes). In addition, the initial cost can be taken as a one-time or as an average between the start and end point.

The advantage of the method is ease and clarity, the disadvantages are ignoring the cheapening of money, the duration of the operation of assets, focusing more on an external user.

In addition to those mentioned above, other simple methods of evaluating investment projects are used. They give a vision of the most general indicators, based on which, you can proceed to more detailed calculations.


Net cash receipts (NV, or NPP) are the positive balance of the flow of money for the period under review.

Net cash receipts

where is:

• Pm is the sum of the money inflow at step m;
• Om is the sum of the outflow of money at step m.

Investment return index. This is the ratio of the flow from the main activity to the sum of the flow from the investment activity. It can be represented in the form of a formula:

Investment Return Index

in which:

• K – initial investment;
• Pm and Om – inflow and outflow of funds.
• This indicator indicates the return on investment relative to net cash flow and the total amount of investment.

Cash outflow is maximum (CO). It represents the maximum negative balance and shows what the least amount of external funding from any source is needed in order for the initiative to be implemented.

Dynamic (discount) methods of analysis

For a more detailed and professional study of the issue, indicators for assessing the effectiveness of investment projects based on the concept of discounting are used. Let us dwell on the most important of them.

The most common and important criterion in the evaluation and analysis of an undertaking is the indicator of net discounted income, or net present value (NPV, or NPV). This is the effect of the flow of funds, reduced to the current value. Its formula looks like this:

NPV

where the discount coefficient expressed in part of the formula is taken into account


NPV shows the ratio of investment costs and money receipts in the future, which are brought to current conditions. For its correct calculation, it is necessary to determine the norm (rate) of bringing, and then calculate the discount coefficient.



Using its value, you can easily find discounted amounts of inflows and outflows of funds, and the current net worth is the difference between them, which can have different meanings:

• a positive value indicates that during the period under study, the volume of revenues will cover the amount of capital expenditures and increase the value of the company;
• a negative value is a signal that the initiative will not lead to the necessary rate of return and will cause losses.

Let's turn to our example. If we take as a basis the discount coefficient of 10%, we get the following result:



NPV = -1000000 + 150000 / (1 + 0.1) + 150000 / (1 + 0.1)2 + 150000 / (1 + 0.1)3 + 150000 / (1 + 0.1)4 + 150000 / (1 + 0.1)5 + 150000 / (1 + 0.1)6 + 150000 / (1 + 0.1) 7 + 150000 / (1 + 0,1)8 + 150000 / (1 + 0,1)9 + 150000 / (1 + 0,1)10 = -1000 + 136,3 + 123,9 + 112,8 + 102,4 + 93,1 + 84,7 + 77 + 70 + 63,6 + 57,8 = - 78,4 thousand rubles.


Thus, we see that at a discount rate of 10%, the undertaking does not cover the start-up costs and will become unprofitable. Therefore, it should be abandoned if there are no options how to lower the discount rate. At the same time, when considering options with a decrease in the discount rate, you need to remember about the methods of assessing the risks of the investment project (lack of profit, poor management, country).


The net present value indicator demonstrates well the minimum required profitability. A positive NPV value indicates a profit, a negative one indicates a loss, close to zero indicates a minimum payback. If in our example we take 9% as the discount rate, then we still get a negative value (-37.4 thousand rubles), so the output to the plus here is possible at a rate not higher than 8%.


A discounted rate index of return (IDD), or, in other words, return on investment (PI). This is the ratio of the reduced flow from internal activities to the reduced flow from investment activity.

PI

Our example here is calculated as follows:

PI = (136,3 + 123,9 + 112,8 + 102,4 + 93,1 + 84,7 + 77 + 70 + 63,6 + 57,8) / 1000 = 921,6 / 1000 = 0,9216


Therefore, we can conclude that each ruble invested in this project will turn into almost 8 kopecks of loss. This method is well suited for determining a more attractive initiative from several available options, especially if some of their other indicators have similar values.


Rate of return (profit, discount) internal (IRR). In projects where there are initial costs and a positive indicator of cash receipts, the internal rate of return is a number with a "+" sign equal to the discount rate, at which the NPV is zero. If the IRR is above the discount rate, then the project may be attractive, if it is lower, then it threatens to lose capital.



Typically, this criterion is calculated by accepting the following assumptions:

• first there are costs and only then begins the inflow of finance;
• receipts are cumulative, the sign changes only once from minus to plus.
• IRR does not have a specific formula. Most often, it is found by building a graph with the values plotted on it. Then, by sequential samples, the closest value of the rate of return is selected. You can also use formulas by which other main indicators for evaluating investment projects are learned.

The problem that we consider throughout the article can be solved in this case using the NPV calculation. In this case, having calculated the interest rate of the discount, at which the net value will be close to zero, you can determine the IRR, it is within 0.08, that is, 8%.



Sometimes the value of this indicator is taken from the value of other related criteria. So, if the initiative is fully financed by a commercial bank, then the maximum allowable interest rate will indicate the IRR value.



The IRR criterion is suitable for screening out unpromising initiatives if the IRR is less than E, as well as for ranking several proposals with similar input data, such as:

• the amount of required investment;
• possible risks;
• the duration of the calculation period.

Payback period discounted (DPP). This is a more accurate calculation of the time required to return the money spent. Unlike a simple payback period, the dynamics of the value of money over time is taken into account here.

DPP

r – discount rate;
CFt is the value of the flow in the t-year.
 

Back to our task. Unlike the method of finding the PP value by a simple method, here it is required to bring all annual revenues to the current state at the previously accepted rate of 10%. By year (from the first to the tenth) it looks like this: 136.3 + 123.9 + 112.8 + 102.4 + 93.1 + 84.7 + 77 + 70 + 63.6 + 57.8 = 921.6 thousand rubles.


The result indicates that during the life cycle of the initiative (10 years), this investment will not pay off. Here you can clearly see the difference between the objectivity of calculations by a simple method and using the reduction of money flows. 

If the investor relies on a simple method that is poorly applicable in long-term projects, then he will incur losses, since the PP was equal to 6 years and 7 months. If the DPP is taken as a basis, then the entrepreneur is likely to refuse this offer altogether or in favor of another possible option.