Thursday, 17 February 2022

Criteria for evaluation of investment projects

The process of making managerial decisions of an investment nature is based on the assessment and comparison of the volume of anticipated investments and future cash receipts. The general logic of analysis using formalized criteria is in principle quite obvious - it is necessary to compare the amount of required investments with the projected income. Since the indicators being compared refer to different points in time, the key problem is their comparability. It can be treated differently depending on the existing objective and subjective conditions: the rate of inflation, the size of investments and generated revenues, the forecasting horizon, the level of expertise of the analyst, etc. 


Critical moments in the process of evaluating a single project or drawing up an investment budget include: 

a) forecasting sales volumes taking into account the possible demand for products (since most projects are associated with additional output); 

b) assessment of cash inflows by year;

c) assessment of the availability of the required sources of financing; 

d) assessment of the acceptable value of the price of capital, used, among other things, as a discount coefficient. 


Analysis of the possible capacity of the market for the sale of products, i.e. forecasting the volume of sales, is the most significant, since its underestimation can lead to the loss of a certain share of the sales market, and its revaluation - to the inefficient use of the production capacities introduced under the project, i.e. to the inefficiency of the investments made. With regard to the estimation of cash inflows by year, the main problem arises with regard to the last years of project implementation, since the further the planning horizon, i.e. the longer the project is in time, the more uncertain and risky the cash inflows of distant years are considered. 


Therefore, several calculations may be made in which reduction factors may be introduced for the income values of the last years of the project, or these revenues may be excluded from the analysis altogether due to significant uncertainty. As a rule, companies have many projects available for implementation, and the main limiter is the possibility of financing them. Sources of funds vary significantly in the degree of their availability - the most accessible own funds, i.e. profit, further in the degree of increase in the mobilization period are bank loans, loans, new emission. 


As noted above, these sources differ not only in the length of their involvement in the investment process, but also in the price of capital, the amount of which also depends on many factors. In addition, the price of capital attracted to finance the project, during its implementation, may change (usually upwards) due to various circumstances. This means that a project that is accepted under some conditions may not be profitable under others. Different projects react differently to an increase in the price of capital. 


Thus, a project in which the bulk of the cash inflow falls on the first years of its implementation, i.e. the reimbursement of cash investments is carried out more intensively, is less sensitive to an increase in the price for using the source of funds. From a formal point of view, any investment project depends on a number of parameters that are subject to evaluation during the analysis process and are often specified in the form of a discrete distribution, which allows this analysis to be carried out in the simulation mode. In the most general form, the investment project P is the following model:

P = (IC , CF , n , r),

I k

Where IC is an investment in the I-th year, I = 1,2 ...,( most often it is considered that m = 1 )

CA – inflow (outflow) of funds in the current year, k = 1,2,....n;

n – duration of the project; r is the discount ratio.

Investment projects analyzed in the process of drawing up the budget of capital investments have a certain logic.

- With each investment project, it is customary to associate cash flow, the elements of which are either net outflows or net cash inflows; in this case, net cash outflow in the year is understood as the excess of current cash expenditures on the project over current cash receipts (respectively, with an inverse ratio, there is a net inflow); sometimes the analysis does not use cash flow, but a sequence of forecast values of the net annual profit generated by the project.

  • Most often, the analysis is carried out by year, although this restriction is not unconditional or mandatory; in other words, the analysis can be carried out according to equal base periods of any duration (month, quarter, year, five-year period, etc.), it is only necessary to remember about linking the values of the elements of cash flow, the interest rate and the length of this period.
  • It is assumed that the entire volume of investments is made at the end of the year preceding the first year of the cash inflow generated by the project, although in principle investments can be made over a number of subsequent years.
  • The inflow (outflow) of funds takes place at the end of the next year (such logic is quite understandable and justified, since, for example, this is how profit is considered to be the cumulative total at the end of the reporting period).
  • The discount ratio used to evaluate projects using methods based on discounted estimates should correspond to the length of the period laid down in the basis of the investment project (for example, the annual rate is taken only if the length of the period is a year).

It should be emphasized that the application of methods of evaluation and analysis of projects implies a multiplicity of forecast estimates and calculations used. Multiplicity is determined both by the possibility of applying a number of criteria, and by the unconditional expediency of varying the main parameters. This is achieved by using simulation models in a spreadsheet environment.

The criteria used in the analysis of investment activities can be divided into two groups depending on whether or not the time parameter is taken into account: (a) based on discounted estimates; b) based on accounting estimates. The first group includes the following criteria: net effect; roitor index; internal rate of profit; modified internal rate of return; discounted payback period of the investment. The second group includes the following criteria: payback period; ROI.

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