Indicators of investment project evaluation

Why do we need an investment project?

The investment project is drawn up to attract investment for the implementation of the idea. At the same time, investments should be expedient, have specific deadlines and established volumes.

When investors consider projects, they want to find a way to preserve or increase capital. To make a competent choice, they assess the potential income, timing and risks.

In the article, we will analyze what methods exist for evaluating investment projects, what indicators investors consider and how to calculate them.

Main indicators of evaluation of investment projects

There are two types of modern methods for evaluating investment indicators: statistical and methods based on discounting.

The main difference between statistical and discounting methods is that they do not take into account the time value of money.

In 1999, scientists Graham and Harvey tried to find out what methods are used in practice by financial directors of American companies. They sent a questionnaire to 4440 companies, in which they asked to indicate the most commonly used methods of evaluating projects. Responses were received from 392 respondents.

The results of the study showed that large firms (with sales of up to $ 1 billion) prefer indicators of internal rate of return (IRR) and net discounted value (NPV), not always taking into account the payback period (PBP) and discounted payback period (DPP) in contrast to small enterprises (with sales levels up to $ 100 million).

Money today is more valuable than tomorrow

The rule is based on the concept of the time value of money, when having 100 Dollars today is more profitable than 100 Dollars tomorrow.

There are two projects with the same investment and return, but at different times. According to the concept - preferably the one that will return the money faster - project B, since the return and interest received over two years can be invested in other projects.

Period	Project A	Project B
0	-100	-100
1	30	75
2	30	75
3	30
4	30
5	30

Higher risks, greater returns

Investing in a less reliable project increases the risk of losing money. There are two options: put money in the bank at 10% per Annum or invest in a startup at 20%. At first glance, investing in a startup will bring more income, but it is worth considering the higher risk of losing money.
If we compare projects:

With the same income, then projects with less risk are preferable;
The same risks, then projects with a higher income are preferable.

Payback period

The period during which the project recoups the investment.
There are two projects with different investments and income.

Period	Project A	Project B
0	-100	-10
1	50	15
2	50	15
3	50	15
Total	150	45

Project A will bring more than Project B, but it requires a higher amount of investment to return. In addition, Project B will return the invested money faster and more for each Dollar invested. Which one to choose depends on the strategy of investors. Some investors set a limit on the payback period, for example, do not accept projects that pay off for more than a year. In this case, project B is more attractive, despite the smaller profit.

To calculate the payback period, you need to divide the investment by the average annual profit. For Project A, the average annual profit is 50, so 100/50 = 2 years is the period in which the project will pay off. The average annual profit of project B is 15, which means 10/15 = 2/3 years = 8 months - the payback period of project B.

The payback period does not yet indicate the profitability of the project, because it does not take into account the risks. To take into account all the factors of assessing investment indicators in economic theory, the concepts of discounting and NPV appeared.

Discounting and NPV

Suppose that investors invest in the project at 10% per Annum.

	Today	A year later	After 2 years
Investment	100$	110$	121$

A refund of 110$ after a year is equal to a return of 121$ after two years. If the project owners abandon the project before the start, they will have to return 100$ to the investor without interest. It follows that 100$ today, 110$ in a year and 121$ in two years are equivalent.

Discounting is based on bringing to a similar equivalence – we are trying to see how much future money is worth in "today's money"

To discount cash flows, use the formula:

n, t is the number of time periods;
CF — cash flow;

i is the discount rate or percentage at which investors are willing to invest money in the project.
To get net present value (NPV) – the cost of the project in "today's money", you need to add up all the discounted cash flows and deduct the initial investment.

If the NPV >0 – the project is worth accepting, it will bring more than is required by investors.
With NPV <0, we receive an amount that the project owners must compensate the investor today to take part in the project.

Let's calculate the NPV for the project: the investment amount is 500%, the cash flow period is 4 years, the discount rate is 12%.

Let's calculate cash flows to current value:

DCF1 = 100 / (1+0,12) = 89,29
DCF2 = 100 / (1+0,12)² = 100 / 0,7972 = 159,44
DCF3 = 300 / (1+0,12)³ = 300 / 0,7118 = 213,54
DCF4 = 400 / (1+0,12)⁴ = 400 / 0,6355 = 254,20

The amount of discounted cash flows is 716.47

Period	CF	R	DCF
0	-500		0
1 year	100	0,8929	89,29
2 year	200	0,7972	159,44
3 year	300	0,7118	213,54
4 year	400	0,6355	254,2
Altogether	1000		716,47

NPV = PV-I, where I is the sum of the initial investment.
NPV = 716,47-500 = 216,47

Essentially, an NPV is an additional profit in excess of the required amount that the investor must pay to get a stake in the business. If the NPV is negative, then this is the amount that the organizers of the project must reimburse the investor so that he wants to invest his money.

If two projects with the same costs are considered, then a project with a large NPV is not always accepted. A project with a smaller NPV, but with a shorter payback period, can be more profitable than a project with a larger NPV.

Internal rate of return

(Internal Rate of Return – IRR) is the value of the discount rate at which the net reduced income (NPV) is zero. The indicator reflects the maximum interest rate at which you can invest in the project.

The x-axis is the discount rate as a percentage, y is the NPV of the project. As the discount rate increases, the net quoted income tends to zero. Where the curve crosses the x-axis, and there will be a sought IRR value.

With values:

IRR > r - the income required by investors is less than the IRR, so the project is worth accepting.
IRR < r - to refuse, because the project will not bring the required income to investors.

When we compare several projects or financial instruments with the same discount rate, those whose IRR indicators are higher are preferable.

Let's use the formula "VSD" in Excel. It is needed to calculate the IRR indicator.

Period	CF
0	-500
1	100
2	200
3	300
4	400
	IRR = 27%

The IRR is 27%. With a discount rate of 12%, IRR> r, so the project is worth considering.

Discounted payback period

The Discounted Payback Period (DPP) shows over what period of time the amount of discounted cash flows will cover all discounted investment costs. That is, from what moment the investor will recoup the costs and begin to receive additional profits.

When using this method when comparing multiple projects, it is worth choosing one that has a lower DPP value.

Formula for calculation:

Let's calculate the discounted payback period for the project: the amount of investment is 500 Dollars, the cash flow period is 4 years, the discount rate is 12%

The payback period of the project will be 3 years, since it is during this period that the amount of cash flows will exceed the amount of the initial investment.

The discounted payback period of the project is 4 years.

If only this method is used to evaluate projects, then from several alternative projects, under equal conditions, the project that has a lower DPP value is accepted. The disadvantage of the method is that it does not take into account the cash flows that can be received after the end of the payback period.

Profitability Index

The Profitability Index (PI) is the ratio of NPV to discounted investment volume. It shows how many additional Dollars the investor will receive for each Dollar invested.

The index is calculated by the formula: