Project Valuation methods with Invest Sign

Investment appraisal is one of the main parts which is very important accepting or rejecting a project. This topic is frequently tested both in the examination paper and the project. So a good understanding of the ways, in which investments are appraised, is important. In this article, you can look at the principles and practical issues relating to particular methods of investment appraisal.

Investment decisions are very important to a business. They tend to involve large sums of money and their impact on the survival and prosperity of the business can be profound. Once an investment decision has been made, and the funds committed, it is often difficult to abandon the project without significant losses being incurred.

In practice, there are four major methods of evaluating investment proposals:

    Net present value (NPV) method

    Internal rate of return (IRR)

    Payback period (PB)

    Profitability index (PI)

Additionaly three methods are used:

    Modified Internal Rate of Return (MIRR)

    Discounted Payback period (DPB)

    Accounting rate of return (ARR)

Practicle example and calculation of the methods

In this example we will look at calculations of valuation methods for project without external sponsorship.

The detailed calculations of project are listed below:

Invest Sign allows to export these and other financial reports to selected format (MS word, Excell or others) to give better opportunity to analyse and use data. In this example, we exported IRR calculation without external sponsorship table:

Table 19. IRR calculation without external sponsorship

Net Present Value (NPV)

In simple terms, NPV is the difference between an investment’s market value and its costs. The “P” in NPV means that we will derive a single euro value for the investment today even though the life of the project may span many years. We begin by estimating the future cash flows of the project results. For purposes of these calculations, any cost saving or incremental revenues to the organization as a result are considered “inflows” (P) and are positive numbers. All costs are considered “outflows” (IC) and are negative numbers, i is a discount rate.

NPV is given by the following expression:

or

The hypothetical example below assumes that the lifecycle of the project is 5 years. Numeric cost savings assumptions were made as well. The NPV for project without external sponsorship is 43 104 euro.

Internal Rate of Return (IRR)

The IRR is the discount rate that makes the NPV of a project equal zero. For purposes of these calculations, any cost saving or incremental revenues to the organization as a result are considered “inflows” (CF) and are positive numbers. All costs are considered “outflows” (Io) and are negative numbers. The irr is found by solving the following expression:

The IRR provides us with a single rate of return that summarizes the merits of the project. For our example above, when you set the NVP to zero, the IRR is 16,32 %, which is well above our required rate. This tells us that we should undertake the project. Just one quick word of caution about IRR calculations, they work for conventional project cash flows, meaning that the first cash flow (initial investment at time zero) is negative and all of the remaining cash flows are positive. If the cash flows are not conventional, then you will have multiple rates of return where the NPV is zero. In the case of non-conventional cash flows, use the NPV method only. If the cash flows for multiple projects are conventional, then the IRR method is a great way to compare projects because you can talk in terms of rates of return instead of euro amounts (NPV).

Payback Period (PB)

The payback period is the amount of time needed for an investment to generate cash flows to recover its initial costs.

The payback period method has some serious shortcomings though. It is calculated by simply adding up the future cash flows. There is no discounting of cash flows, so the time value of money is ignored. Without discounting the future cash flows, your project will look much more attractive than it really is. Not only will the project look more attractive, but since there is no required rate of return used, the risk level of the project is never captured. This means that a very risky project is treated the same as a low risk project. The biggest shortcoming with the payback method is that there is no economic rationale for determining the correct cutoff period. An arbitrary cutoff period must be chosen, so you need to decide whether 2 years is acceptable, or 4 years, or 5, etc. The payback period also tends to bias the user toward short term investments as it ignores cash flows beyond the cutoff. A project that takes a few years to get up to speed and then creates phenomenal returns would be rejected strictly on its cash flow profile.

With all of the shortcomings of the payback period method, it is easy to see why you should put very little weight on the analysis results other than as a very general guide when looking at two fairly comparable projects. If payback period is a valuation metric that your organization tends to look at, you can and should perform a discounted payback period analysis where you determine your discount rate and discount the future cash flows before performing the payback analysis. This would eliminate the some of the shortcomings mentioned above, but very few individuals ever perform such an analysis in practice. Use the discounted payback method only as a quick and dirty valuation method to value a project on the “back of an envelope” and as just another valuation metric in conjunction with the others mentioned here. Do not base your accept/reject decision upon it. The payback period for project is 4,19 year.

Profitability Index (PI) or Benefit/Cost Ratio

The PI is the present value of future cash flows divided by the initial investment. The present value of future cash flows is another term for discounted cash flows calculated exactly as shown in the NPV section.

or

The PI would be larger than 1 for positive NPV projects and less than 1 for negative NPV projects. For our example above the PI would be 1.0139. The PI measures “bang for the buck”. It tells us that for each euro invested, the organization receives $1.01 in value. The PI and the IRR valuation methods are obviously very similar to the NPV method. They just present the results in a different fashion. An attractive NPV project will also look attractive on an IRR or PI basis and vice versa. IRR and PI allow you compare multiple projects on a level playing field. Just be careful, because it might make more sense for your organization to pursue a high NPV project even though it carries a lower IRR and PI than another comparable project. Earning a 50% return on a $20,000 project might not add much value to your organization, whereas earning 22% on a $5 million project would add considerable value.

Modified Internal Rate of Return (MIRR)

The Modified Internal Rate of Return (MIRR) is used to correct a significant inherent problem with the IRR calculation. The IRR formula assumes that you are reinvesting the cash flow at the same rate as calculated by the IRR. As a result, when you have a property that generates significant cash flow, the calculated IRR will overstate the likely financial return of the property. The MIRR allows you to enter a different rate that is applied to the property's cash flow. Using the MIRR will more closely mimic the real rate of return since operating cash flow is rarely invested at a higher rate than a bank savings rate. The MIRR is 12,45 %.

Discounted Payback Period (DPB)

The discounted payback period is the amount of time needed for an investment to generate cash flows which are discounted to recover its initial costs. The discounted payback period is 4,94 year.

It is calculated by simply adding up the discounted future cash flows. The biggest shortcoming with the discounted payback method is that there is no economic rationale for determining the correct cutoff period. An arbitrary cutoff period must be chosen, so you need to decide whether 2 years is acceptable, or 4 years, or 5, etc. The discounted payback period also tends to bias the user toward short term investments as it ignores cash flows beyond the cutoff. A project that takes a few years to get up to speed and then creates phenomenal returns would be rejected strictly on its cash flow profile.

Average accounting returns (ARR)

The average accounting return (ARR) is the (undiscounted) average project earnings after taxes and depreciation, divided by the average book value of the investment during its life. The rule then accepts projects with an accounting return greater than a cutoff rate. The ARR is 47,38 %.

    The first problem with this rule is that it is based on net income figures and the book value of investments. Both of these measures are contaminated by arbitrary decisions about the depreciate rate of assets that are intrinsically irrelevant to the investment process. By contrast the NPV rule uses cash flows.

    The second problem with the AAR rule is that, like the payback period rule, it ignores discounting and therefore does not take account of the opportunity costs of investing funds in the project.

    The third problem with the rule is that, since it is not related to NPV in any obvious way, there is again no rational basis for choosing the cutoff rate of return.