How to determine the effectiveness of an investment project

The essence of evaluating an investment project is to adequately determine today's costs and future revenues. To analyze the effectiveness of investments, a system of indicators is used. But it must be borne in mind that the investment decision is being applied at the moment, which means that project indicators should be calculated taking into account the decrease in the value of money in the future.

Instruction manual

1

In order to evaluate the investment project, you need to know the discount rate. It is the rate at which future cash receipts are reduced to their 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 risk level of investment in the project.

2

One of the criteria reflecting the effectiveness of an investment project is net present value (NPV). To calculate it, use the following formula:

NPV = Σ (Pi / (1 + r) ^ i) - I, where

P - 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, because the investment will pay off and will bring profit to the investor. The criterion of net present value is used as the main one, since the NPV of various projects can be summarized.

3

When analyzing an investment project, you should also calculate the internal rate of return (IRR). It represents a value of the discount coefficient at which the criterion NPV is equal to zero. The economic meaning of this calculation is that the internal rate of return shows the level of expenses associated with this project that the investor can allow. For example, if a project is financed by a loan, then the rate of return reflects the upper limit 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 necessary for the implementation of the project, then it should be accepted, if lower - rejected. If the IRR criterion is equal to the relative price of the source of financing, this means that the project is neither profitable nor unprofitable. In other words, the internal rate of return is a boundary indicator: if the relative price of capital exceeds its value, then as a result of the project it will be impossible to ensure the return on investment and their return.

4

In addition, you can use the Return On Investment Index (IR) to measure your investment performance. 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 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.