When analyzing whether or not to carry out an investment project, it is necessary to use certain financial indicators that allow us to make an objective decision. These indicators tell us if the project is viable or not. This article explains the different aspects that must be taken into account for a correct calculation of the Net Present Value (NPV), the Internal Rate of Return (IRR) and the Recovery Period (PR).
The Financial Evaluation of a project consists of consolidating everything we find out about it (sales estimates, necessary investment, operating expenses, fixed costs, taxes, etc.) to finally determine what its profitability will be and the value it will add to the investment initial. Below I detail the steps to follow for an effective financial evaluation:
1. The first thing to do is decide what will be the duration of the project's life (Eg: 5 years). Most likely, this period is uncertain for the decision maker. What can be done in these cases is to take a “reasonable” period for the type of project in question, which reflects the maximum number of years that the person who is going to invest could wait to recover his initial investment and the assumption is made that the company's assets are sold in the last year of the period.
2. Then you must decide how many periods the life of the project will be divided into. That is, if the evaluation is carried out on a monthly, quarterly, semi-annual, annual basis, etc. For example, if I choose to divide the life of the project into months, that means that I will have to calculate income, expenses, investment, depreciation, taxes, etc., on a monthly basis. The normal thing is that the periods are annual.
3. Then I must determine the opportunity cost rate (To). The To is the best rate I could get, investing the same money in another project with a similar risk.
For example, I can have $ 100,000 and I have the option of setting up a clothing store. I also know that the normal rate of return of a clothing sales house is 30% per year, that of a Fixed Term is 15%, that of an oil extraction project is 50% and that of a sales business of footwear is 35%. Which of these rates do I take?
The answer is 35%. Why? We discard the fixed term rate because it has much less risk than a clothing store. The oil extraction project is also ruled out for two reasons: first, it has much more risk than the clothing house and second, it is probably not an option for the investor since he only has $ 100,000, and to be able to use the rate should be really viable options for the investor.
We are left with the rates of a shoe sales business (35%) and the normal rate of return of a clothing business (30%). It can be said that these two projects have a similar risk and that both are viable for the investor, so we must take the higher, which in this case is 35%.
It should be clarified that if in the previous step we choose monthly periods to evaluate the project, To must also be determined on a monthly basis. If we choose to divide the project into annual periods, the To must be annual.
What usually happens is that it is very difficult to determine this opportunity cost rate, because we do not have the necessary information. So what you do is, for example, take the normal rate of return for a fixed term and add a bonus for the risk associated with the project in question.
For example, if the rate of return of a fixed term is 15%, we add 10% for a project with little risk, or we add 40% for a very risky project, obtaining a To of 25% or 55% respectively.
It should be noted that this method is very subjective and there is a risk that the final evaluation will not reflect reality.
4. Next, the amount of the initial investment and the net cash flows for each period in which the project is divided must be determined. That is, the result for each period of the income and expenditure of funds. Ex:
Year 0 is used to record the initial investment. And then, in each of the following years, the income and expenses generated by the normal operation of the project are recorded. That does not mean that there can be 2 or more investment periods without any type of income, as it could be, for example, in a building construction project. What would look like this:
When assembling the flows, you must always bear in mind that they are only money movements. They are not the same income and expenses that appear in the income statement of a company. For example, if it is expected that in period 1 a credit sale will be made, which will be paid to us in period 3, in which period is it recorded? The answer is in period 3, which is when the money actually comes in. While in the income statement, the sale will appear in period 1.
5. Finally, the indicators that will help us make the final decision are calculated. The most used indicators are the Net Present Value (NPV), the Internal Rate of Return (IRR) and the Payback Period (PR):
GO
GO
The results can be:
NPV less than 0: The project is not profitable. The return on the project is not enough to cover the opportunity cost rate.
NPV greater than 0: The project is profitable. The project gives a return greater than the opportunity cost rate.
VAN equal to 0: Indifferent. It means that the project is yielding the same to me as the opportunity cost rate.
IRR
The IRR represents the project's rate of return. To calculate it, we start from the NPV formula, make NPV = 0 and solve for «tir».
The calculation is very complex, so it is usually done with a financial calculator or by computer (Excel has a predefined formula to calculate the IRR).
The results can be:
IRR greater than To: carry out the project. The project gives a return greater than the opportunity cost rate.
IRR less than To: do not carry out the project. The project gives a lower return than the opportunity cost rate.
IRR the same as To: the investor is indifferent between carrying out the project or not. It means that the project is giving me the same as the opportunity cost rate
Recovery Period
It is the time in which the investor recovers his Initial investment. Ex:
In the previous example we see that $ 1200 was invested and 420 are recovered in year 1, 550 in year 2 and the rest in year 3. With which we can say that the project allows to recover the initial investment in 3 years. The decision, in this case, depends on the investor and the length of time they are willing to wait to recover their investment. All three criteria should be used together to make the decision. If we only look at one we can risk making a wrong decision.
