Thursday, 17 February 2022

Criteria for evaluating an investment project


Simple, static criteria for the effectiveness of investment projects include the payback period and a simple rate of return.

The payback period refers to the expected period of recovery of the initial investment from net proceeds (where net proceeds represent cash receipts less expenses).

The main disadvantage of the payback period as a measure of efficiency is that it does not take into account the entire period of operation of the investment and, therefore, it is not affected by all the returns that lie outside it. Therefore, this indicator should be used as a constraint in decision-making.

A simple rate of return is similar to a return on equity and shows how much of the investment cost is recovered as profit within a single planning interval. Based on the investor's comparison of the estimated value of the rate of return with the minimum or average level of profitability, a conclusion is made about the expediency of further analysis of this investment project.

The main advantage is its simplicity, which allows it to be used for small firms with a small cash turnover, as well as for quick evaluation of projects in conditions of resource scarcity.

Disadvantages of the simple rate of return criterion:

there is a great dependence on the net profit chosen as the rate of comparison, the value of future revenues is not taken into account and the estimated rate of return plays the role of the average for the entire period.

Criteria based on the technique of calculating the time value of money are called discounted criteria.

Net discounted revenue is a discounted measure of the value of a project, defined as the sum of discounted revenue values minus the costs received in each year over the life of the project.

To be recognized as effective from the investor's point of view, it is necessary that his net discounted income be positive; when comparing alternative projects, preference should be given to a project with a higher value of net discounted income (provided that it is positive).

The internal rate of return is technically a discount rate at which the project breaks even, meaning that the net discounted value of the cost flow is equal to the net discounted value of the revenue stream.

The disadvantage of the internal rate of return thus determined is that such an equation does not necessarily have to have one positive root. It may have no roots at all or have several positive roots.

Profitability indices characterize the return on the project on the funds invested in it. They can be calculated for both discounted and undiscounted cash flows. There are cost return indices and investment return indices. The value of profitability indices for effective projects should be greater than one.

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