In order to develop business, owners and managers need to constantly look for ways and resources that will contribute to increasing market share, enhancing competitive advantages, diversifying, etc. Investing is an interesting solution for business strengthening. How to evaluate its effectiveness? There are four most common methods of such evaluation today.
Net Present Value (NPV)
The name is self-explanatory – net income or loss as a result of capital investments, expressed in the present value. NPV is the difference between the discounted amount of cash receipts and expenses. That is, the future additional capital that an investor will receive, taking into account the time value of money.
In order to make a decision on investing in a project, it is enough to have its NPV not less than “0”. This indicates that the required level of profitability has been achieved: incomes cover costs, and the invested funds are returned not undervalued.
In order to compare alternative investment options, one that has a larger absolute NPV is usually chosen. If investment funds are limited, and there are a lot of long-term projects, it is necessary to conduct a capital valuation procedure aimed at determining the best distribution of available funds and maximizing the total net present value of chosen projects. In order to do that it is necessary to rank projects according their indexes of return (unit of NPV per unit of invested capital) from the largest to the smallest, and accordingly allocate investment funds.
The calculation of net present value is considered to be the most effective and widespread way to evaluate investment projects.
Internal rate of return (IRR)
In order to calculate the net present value of an investment project, a nominal value of capital is used to bring cash flows to its present value. An alternative way is to determine the internal rate of return of a project and compare it with the cost of capital or the required level of profitability.
IRR is the rate at which the project reaches zero net discounted value. Investments are considered to be recommended when this indicator is equal to or exceeds the cost of capital or the rate of return of the company.
In order to calculate the internal rate of return, it is necessary to discount cash flows at two different rates, and then, applying a linear interpolation formula to the two derived IRR, determine the rate at which the IRR = 0. Of course, the result will not be perfectly accurate, since subjective assumptions are used.
Payback period
A quick and practical way to evaluate and compare investment projects is to determine the period during which the money spent will be reimbursed. This method is based on expected cash flows and indicates the level of liquidity and risk – the sooner the investor will return the invested amount, the sooner he/she can invest again, that is, the liquidity will be higher and the risk – the lower. This is particularly true in conditions where the investment climate is being adjusted and it makes sense to give preference to projects that will release more money soon.
Accounting rate of return (ARR)
Accounting rate of return is an indicator of the profitability of an investment project, calculated as the ratio of accounting profit to the average value of invested capital. The result is compared with the normative level of return and the projects that are being achieved are adopted.
The choice of method for evaluating investment proposals and making capital expenditure decisions is individual for each business and specific project. It depends on how quickly it is necessary to solve the question of what resources and competencies are available for the preparation of the calculations and what is the ratio between the amount of required capital, the potential profit and the level of the risk involved.
