The essence of the investment project appraisal lies in the adequate determination of today's costs and future receipts. A system of indicators is used to analyze the effectiveness of investments. But it must be borne in mind that the investment decision is applied at the moment, which means that the project indicators should be calculated taking into account the decrease in the value of money in the future.
Instructions
Step 1
In order to evaluate an investment project, you need to know the discount rate. It is the rate at which future cash receipts are reduced to present value. The discount rate is calculated as the sum of the inflation rate, the minimum real rate of return that the investor wants to receive, as well as the level of risk of investment in the project.
Step 2
One of the criteria reflecting the efficiency of an investment project is the net present value (NPV). To calculate it, use the following formula:
NPV = Σ (Pi / (1 + r) ^ i) - I, where
P is the net cash flow for each period;
r is the discount rate;
I - initial investment, i - the number of periods of receipt of funds.
If this indicator takes a positive value, the project is accepted, since the investment will pay off and bring profit to the investor. The net present value criterion is used as the main one, since the NPV of various projects can be summed up.
Step 3
When analyzing an investment project, you should also calculate the Internal Rate of Return (IRR). It is the value of the discount rate at which the NPV criterion is zero. The economic sense of this calculation is that the internal rate of return shows the level of costs associated with a given project that an investor can afford. For example, if a project is financed by a loan, then the rate of return reflects the upper bound of the interest rate, the excess of which makes the project unprofitable. Thus, if the IRR is higher than the price of the source of capital required for the implementation of the project, then it should be accepted, if lower, it should be rejected. If the IRR criterion is equal to the relative price of the source of funding, then this means that the project is neither profitable nor unprofitable. In other words, the internal rate of return is a borderline indicator: if the relative price of capital exceeds its value, then as a result of the implementation of the project it will be impossible to ensure the return on investment and their return.
Step 4
Alternatively, you can use the return on investment (IR) index to assess the performance of your investment. It is calculated as follows:
IR = Σ (Pi / (1 + r) ^ i) / I.
This criterion is a consequence of the net present value method. If the profitability index exceeds 1, the project is effective, investments will bring the investor income, if below 1 - unprofitable. If IR = 1, then the investment in the project will pay off, but will not bring profit. Unlike net present value, this indicator is relative. It can be used to evaluate projects that have the same NPV.
