HOW TO EVALUATE YOUR PROJECT INVESTMENT?
The identification and selection of good investment projects is a key element in developing a sustainable successful future. The decision to move forward with good or bad projects, more than impacting the economic profile of the firm in the short term, will tend to have a lasting impact in the long term profitability otherwise our spending just an expense.
How to Evaluate an Investment?
The analysis of the projects will be based on their cash flows. We will compare the cash invested and the cash generated by the project. Therefore there won´t be any accounting or similar features that may influence the decision.
Net present value (NPV)
The NPV represents the present value of the stream of cash flows of the project, the principal is Money now is more valuable than money later on.
A positive NPV represents the amount of value generated by the project over the initial investment and over the required rate of return (the discount rate for which NPV is equal to zero). A negative NPV indicates, if the project is taken, a situation of value destruction, as it does not meet the return required by the resources that will be allocated to the project nor compensates for the initial investment.
Internal rate of return (IRR)
Internal Rate of Return is the interest rate that makes the Net Present Value Zero.
The IRR should be compared with the required rate of return used in the computation of the NPV. If the investor’s required rate of return is higher than the IRR, then the project will have negative NPV. If the investor’s required rate of return is lower than the IRR, the project will have a positive NPV and so it can be accepted (from a strictly financial perspective). Therefore, one can see the IRR as equal to the maximum rate of return that an investor may require for a given project. In the analysis of a single project, NPV and IRR lead to the same decision of accepting or rejecting a project.
Payback period
The payback period gives a different perspective of the project comparing with NPV and IRR. It tells us how much time it will take to recover the initial investment made in the project. It is, though, more a criteria of risk than a criterion of return measurement. Payback Period became popular in the 50´s within the multinational American firms that were starting, at that time, their international expansion into countries with unstable environments, in which the awareness of how fast the investment was recovered was more important than the absolute return.
It cannot be viewed as a measure of value or return as it ignores all the cash flows after the initial investment is recovered. In any case and, just looking at a single project, it will lead to the same decision of NPV or IRR unless we have negative cash flows after the recovery of the investment. In fact, if the initial investment is not recovered throughout the life of the project, this means that NPV will be negative. On the other hand, if the initial investment is recovered, this means that after that moment, all cash flows are a plus regarding the initial investment, and so project’s NPV is positive. Interesting cases are the ones in which, at the end of the project, there is a negative cash flow such as in the case of the closure of a mine or of an electrical plant.
Summary
Investing is where we use money to make more money, hence we need to spend the money wisely. There are several methods to analyse whether our investment good or not. Net Present Value is one of the method. The basic principal is money now is more valuable than money later on. Other methods we can use are Internal Rate of Return, Payback Period and Profitability Index. Based on those methods we can identify and select our project investment.
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Easy to understand for beginners like me… thank you for the insight pak.
This is power full tools to get money from the Bank Pak..
nice share pak, one of the best ways to determine whether or not to invest..
Nice article Mr. Totok, but i have a question, how to determine accurately the discount rate as we know that incorrectly determine a discount rate, a multi billion dollar investment will be at stake its profitability
Nice article Pak (y).
The trickiest thing is how to forecast/calculate projected cash flow generated from the project. What’s the best way to do that?