Friday, 7 May 2021

The effectiveness of the investment project

 




When studying questions about the prospects of investing in a venture, the most important criterion is the economic efficiency of the project. 

In order to avoid misunderstandings in the business environment, there are generally accepted indicators of the economic efficiency of investment projects. They characterize the initiative from different angles, including from the point of view of lean production, which helps the investor to make informed decisions.

What are the key performance indicators

 

Any design project has two parts: narrative and calculation. If the first describes the very essence of the idea, the prospects for its implementation and promotion of the product in the market, the second contains technical and financial calculations, including the calculation of indicators of the effectiveness of the investment project. 

 

The definition of economic efficiency is understood as a result, obtained after a comparison of the level of profitability of production to the resources used and the total cost of it.

The essence of lean production and economic efficiency is to get the maximum number of products from available resources with the condition of their payback and profit. This concept is multifaceted, it is impossible to evaluate it on any one indicator, it is necessary to approach the issue in a comprehensive way.

The economic effectiveness of an investment project is usually assessed on the basis of such criteria:


  • Net value(net discounted income),or NPV;
  • Internal rate of return (IRR);
  • Domestic modified rate (MIRR);
  • Yield Index (PI);
  • Starting investment (PP) payback period
  • Payback period discounted to reflect the change in the value of money (DPP);
  • ROI rate weighted average (ARR).




Many experts, conducting an analysis of the economic efficiency of the investment project, do not study in detail all the indicators, limiting to 3-4 most significant of them. This mainly depends on the area of activity or industry in which investments are expected to be invested.


There are methodical recommendations that link the main indicators of the effectiveness of an investment project to certain entities:


  • To a separate company;
  • A legal or individual who has acted as an investor;
  • Shareholders who have invested in the undertaking;
  • Higher-level structures
  • Budgets at different levels
  • society in general.



This raises different criteria for the effectiveness of investment projects for different participants:


The effectiveness of the initiative in general characterizes the project, implemented by a single participant for their own money. It is being analyzed to find additional sources of funding or to attract other participants.


The effectiveness of participation in the overall project includes indicators of participation of shareholders, banks, enterprises, various structures (industry or regional) and budgets (from local to federal).


If there are several participants in the initiative, their interests will not necessarily coincide, especially in terms of prioritizing the implementation of certain processes. Special cash flows are formed under each participant, and they can expect different results. Therefore, for each of the participants individually an analysis of the effectiveness of the investment project is carried out.

Absolute criteria by which the project is analyzed


Let's focus on those indicators of the effectiveness of the investment project, which characterize the success of investment in the proposed initiative.

First of all, the given net values considered, as it characterizes in absolute terms the amount of money that the investor will be able to receive during the life cycle of the undertaking. To calculate the cost-effectiveness of a project on this criterion, you need to know the nature of money flows (expense or income) and their distribution over time.

Typically, the most significant expenditure occurs during the per-production period (preparation of documentation and product development), as well as the time of the start of production. Subsequently, costs decrease sharply (or stop altogether), and incomes grow. To calculate this indicator, we use this formula:

Where is:

  • NPV - the value of the money invested is the current net;
  • ICo - the size of the initial investment;
  • CFt - the flow of money from the investment in t - the year;
  • n - the duration of the initiative (its life cycle);
  • r - the value of the discount rate, it can be the cost of capital alternative or weighted average, rate of return or bank credit rate.


Consider an example of the net value. The owner invested $200,000 in equipment upgrades. We will set the discount rate at the level of the company's profitability - 12%. The return on year starting from the first estimated year is:

One year - $40,000;
Two years - $60,000;
Three years - $80,000;
Four years - $100,000.



The net present value of the investment is positive, but its size is small, which should alert the investor, because in any market fluctuations the indicator can become negative. In addition, the discount rate, which we considered as constant, is a dynamic indicator and can vary depending on different factors (refinancing rate, inflation rate, market prices in a particular industry). 

 

Therefore, the evaluation of the effectiveness of such an initiative is generally positive, the money flows it generates reimburse costs and increase the value of the company. However, if the main task is to get maximum profit, then in this case, with a low positive result, the risks of losses are quite high.

The formula reviewed shows a situation in which the investor makes only the initial contribution (at once), but in practice this happens infrequently, as in most productions it is impossible to do without operating capital and overheads. Therefore, taking into account these factors, the formula will take this form:

Where is:

  • ICt investments in the period from i (0) to t;
  • r - discount rate;
  • n is the lifecycle of an attachment.
  • Equally important for investors is the issue of the speed with which they return their invested capital to the project. No one wants to freeze their assets in a long-term initiative with a high degree of depreciation of money. Therefore, the faster the investment returns, the more chances to put this money into circulation again.


Efficiency calculation necessarily includes the calculation of the payback period of initial investments. There is a common formula that looks like this:

Rcy;


Where is:

PP - payback period;
Io - the volume of initial investment;
CFt - t-year flow;
t - time periods.
The calculation is even more simplified if the conditions allow you to calculate the average income from investments over the period. Then the formula is applied:

Rcy;


in which CFcr is an average annual (average monthly, mid-quarter) income from the start-up investment.

However, this approach has a significant drawback - it does not take into account changes in the value of money in the temporary aspect. Therefore, a way to determine the payback period based on discounting is more effective.

DPP


r is the rate of discount money;
CFt is the size of the flow per year t.
Based on the formulas under consideration, we can see that the return period, taking into account the discount, is always higher than in a simple formula. For clarity, we will solve a simple problem on both methods. The initial parameters are as follows: the purchase of new equipment cost the owner of the plant 150,000 euros, the income for the first three years is 50, 100 and 150,000 euros, respectively.

In a simple method of storming the incomes of the first and second year (50,000 to 100,000), we get a figure of 150,000, which indicates that the payback period is exactly two years, and from the third year, the owner will recoup the investment and will make a profit, you can not even count according to the formula.

What will we see if we calculate the discount rate of 15%? All annual revenues will have to lead to the present value:

  • 1 year - 50,000 / (1 q 0.15) - 43,478 euros;
  • 2nd year - 100,000 / (1 q 0.15) - 86,956 euros;
  • 3 years - 150,000 / (1 q 0.15) - 130435 euros.


Accordingly, the average annual rate of return for the first 2 years will be:

CFcr = (43478 + 86956) / 2 = 65217.

Next on the formula. Two years' income is no longer sufficient to cover the costs incurred:

DPP is 150,000 / 65217 q 2.3 years, or 2 years 4 months.

This indicator provides a clear vision of how long it will take to cover the costs incurred, but it has a significant drawback: it is impossible to understand how financial flows will be formed beyond the payback period. Therefore, understanding the effectiveness of projects that are being studied can be distorted.

The above economic efficiency indicators differ in that they show the result in absolute terms (monetary units and units of time). In addition, there are a number of criteria for the potential success of the undertaking, which have the appearance of numerical ratios and are more difficult to understand.

Relative success rates for the project


The calculation of the effectiveness of the investment initiative can be characterized by several more indicators.

The Yield Index is a factor that gives the concept of the profitability of each invested currency at a particular point in time. It is calculated this way:

PI


If you apply this formula to the original task data we were counting on

NPV, you can determine the yield index:

PI = (35714 + 47831 + 56943 + 63552) / 200000 = 1,02

Thus, we get the result, which shows that each dollar invested brings 2 cents of income.

The internal rate of return is calculated on the basis of the condition that the investments are equal to the cash flows they generate, taking into account the discounting.

IC


IRR is an internal rate of return.
This criterion is the rate of return (average) for the full life cycle of the initiative. In addition, he points to the limit rate of return of the undertaking, which is unacceptable to fall below. If the value of the IRR is below the discount rate or equal to it, the project may become unprofitable, this indicator is used when deciding which business offer to accept.

For our example, let's try to determine the value of IRR with a sequential approach method. Consider that the NPV at the rate of 12% was very small (4040 dollars), so let's try to calculate the figure by applying a discount rate of 13%:


Based on this result, it can be concluded that the rate offered in the initial condition is 12% and equals IRR, because when the rate changes in a large way, the net value, taking into account the discount, acquires negative values. Therefore, to invest under a rate greater than 12% in this project is not worth it.

If the project is large-scale and requires large investments, then the owner or shareholders can decide to invest part of the profits in the implementation of the undertaking (reinvestment). In such cases, they use a modified computing mechanism. The formula for domestic modified profitability:

IRR


Where is:

  • r is the discount rate;
  • d - the cost of capital is weightedly weighted;
  • CFt - money flows per year t;
  • ICt - investment flows per year t;
  • n - number of periods.



At the same time, MIRR is always less important than IRR, as investments each year are also based on the state of the start of the project, and all income - by the end of the initiative. It more accurately assesses the state of investment more accurately than IRR, taking into account inflows of positive and negative.

There is another criterion for the success of the undertaking - the efficiency factor of the investment project (ARR), which is tied to the payback period, and is its reverse value.

If there is an average annual return on CFcr capital, the ratio is calculated in this way:

ARR


PP is a payback period for the initiative.

If the whole life cycle is calculated, the formula looks like this:


where If denotes the cost of the liquidation project, which is determined by the sale of all equipment and property after all the work is completed. The PP/1 formula is applicable when If is zero.

We consider the coefficient in our task:





Applying the principles of analysis, which were discussed in the article, you can consider different options, choose from them the most appropriate. In addition, a comprehensive study of the proposed initiatives at an early stage will avoid some risks and control the efficiency of the investment project.

Control over efficiency in lean manufacturing


In recent decades, in developed countries, and now in Russia, there are more and more supporters of so-called lean production in industry. The most common systems of this kind are: 5S, T-S, Just-in-time, TPM, Multi process work.

The essence of lean production is to increase productivity and economic performance through quality management and loss reduction. On this basis, management develops the company's policy and strategy, which aims to use resources only for purposes that give real returns. This assesses not only the work of the entire company, but also each of its structural units, which requires the development of a single methodology for evaluation (quality and quantitative):

A qualitative assessment is made based on production performance and the quality of output;
quantification - on economic indicators, based on accounting.


General reporting in the assessment of lean production in the enterprise may include such sections:



Full implementation of planned activities



  • Losses in a particular unit at the beginning and end of the reporting period;
  • the effectiveness of the introduction of new technologies (in volume, natural and monetary terms) and the justification of their costs;
  • methodical and factual materials (drawings, diagrams, methods, regulatory documents, processes).
  • It is only through the integrated use of all the tools inherent in lean manufacturing that can be minimized or completely solved.



It is important to identify and neutralize hidden losses. The criteria for the efficiency of lean production are analyzed after setting goals and priorities, as well as determining the relationship between the tools of such production and hidden losses, i.e. which tool both reduces certain losses. The closer the planned and actual values are, the better.

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