An important aspect of investment management in the form of investment is to identify and improve the economic efficiency of investments.
In practice, there are two approaches to the definition and evaluation of real investment - cost and income. If we start from the quantitative estimates, up to recently, the economy was dominated by the cost approach, which was reflected in the manner of determining the economic effectiveness of capital investments and the principles of effective options for selection of investment projects based on the methodology of comparative effectiveness, which was based on calculations of cost reduction per unit of production, after the implementation of capital investment.
The income approach involves treatment of capital investments as financial resources for the expanded reproduction of capital assets in order to ensure capital gains enterprise in the form of income (profit) as the ultimate goal of investing. In this approach, the effectiveness of capital investments is determined on the basis of increase of the cost of the company - one of the most common and important principles of the market economy, which should be taken into account when making investment decisions. Based on the principle of increasing the cost of enterprise, investment solutions make sense only if they increase the market value of the enterprise, which is reflected primarily in the increase in the market value of the shares or interests in the company.
Thus, to guide enterprises effect on investment in assets is primarily in the growth of income or cash flows. An important consequence of the acquisition of assets should be the creation of their additional income, increase cash flow and increase company profits in the amount greater than the cost of the newly acquired assets. Ideally, the growth rate of profit must be greater than the rate of growth of production and sales of products, and they in turn are greater than the rate of growth of assets. As a consequence of compliance with this inequality is a growth of return on assets of the business by increasing the return on sales and return on assets. To characterize the efficiency of investments using different indicators: return on assets, return on invested capital, return on equity, etc.
- Net Present Value
Net present value (which was adopted in international practice for the analysis of investment projects, abbreviation - NPV) is the sum of discounted cash flow given by today.
The indicator NPV is the difference between all cash inflows and outflows, reduced to the current point in time (the time of assessment of the investment project). It shows the amount of money that an investor expects to receive from the project after the cash inflows recoup its initial investment costs and recurring cash outflows related to the implementation of the project. Since cash payments are assessed according to their time value and risk, NPV can be interpreted as the value added project. It can also be interpreted as the total profit of the investor.
In other words, for a cash flow, where is a payment after t years (t=1,2,,N) and Invested Capital (IC) such as , NPV can be found by using the following formula:
Where i is a discount rate.
In the generalized form, the investment should also be discounted, since in real-world projects are not carried out simultaneously (in the zero period), and stretched for several periods. NPV calculation - a standard method of evaluating the effectiveness of the investment project and shows the assessment of the effect of the investment, reduced to the present moment of time, taking into account different time value of money. If the NPV is greater than 0, then the investment is cost-effective, and if the NPV is less than 0, then the investment is economically unprofitable (i.e., an alternative project, the profitability of which adopted the discount rate requires less investment to achieve the same revenue stream).
With NPV can also evaluate the comparative effectiveness of alternative investments (with the same initial investments more profitable project with the highest NPV). Still, for a comparative analysis of the more useful are relative indicators. With regard to the analysis of investment projects in such indicator is the internal rate of return.
In contrast to the present value of the indicator in the calculation of the net present value takes into account the initial investment. Therefore, the net present value formula differs from the formula of the present value of the amount of the initial investment.
Conclusions and Recommendations. Pros and Cons of NPV
- Clear criteria for decision-making.
- The indicator takes into account the time value of money (discount rate used in the formulas).
- The indicator takes into account the risks of the project through the various discount rates. Greater discount rate corresponds to greater risks, smaller - smaller.
- In many cases, the correct discount rate is problematic, that is especially true for multi-projects, which are estimated using the NPV.
- Although all of the cash flows (the discount factor may include inflation, but often it is only the rate of return, which is laid in the current project) are forward-looking values, the formula does not take into account the probability of the outcome of the event.
In order to evaluate the project in view of the likely outcome, proceed as follows:
Allocate key input parameters. Each parameter set out a number of values indicating the probability of an event. For each set of parameters and calculated the probability of NPV. Next do the calculation of the expectation. As a result, we obtain the most probable NPV.
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- Accounting Rate of Return
Analysis of ARR
Indicator of the accounting rate of return (ARR) is the inverse of the content of the payback period of capital investment. The estimated rate of return reflects the performance of investment as a percentage of receipts to the amount of initial investment:
Where ARR – accounting rate of return, CF - average annual cash flow from business operations, I0 – invested capital.
The cost of the initial investment, with respect to which is determined by the margin, can have two meanings: the initial cost of the average cost between the amount at the beginning and end of the calculation period. Depending on this, ARR will have different values, so the preparation or analysis of investment projects need to stipulate the method by which this figure was calculated.
Conclusions and Recommendations. Pros and Cons of ARR
This indicator has all the drawbacks of the indicator of the payback period. Index calculation does not consider the return on investment of different value of money over time, ignores the differences in the duration of the assets created through the investment.
The advantage of this indicator is that it is simple and clear in the calculation, and does not require the use of sophisticated techniques such as discounted cash flows.
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- Return of Investment (Payback, ROI, ROR)
Analysis of ROI
ROI (Return on Investment), also known as ROR (Rate of Return) is a financial ratio showing the level of profitability or unprofitability of the business, given the amount of business done in this investment. ROI is usually expressed as a percentage, more rarely as a fraction. This figure may also have the following names: return on investment, return on investment, return on investment, return on invested capital, the rate of return.
The ROI is the ratio of the amount of profit or loss to the amount of investment. The value of income may be interest income, gains / losses on accounting, profit / loss on management accounting or net income / loss. The value of the investment amount can be assets, capital, the principal amount of business and other investments denominated in money.
A simple way to evaluate the effectiveness of investments is to calculate the ratio of the total profits earned during the period of ownership of the investment assets to the value of investments. This figure is called the yield for the period of ownership of the asset. It expresses the extent to which the volume of investments carried up toward the end of the period.
Where - profits earned in each year of the period of ownership of the asset.
HPR = ((value of the investment at the end of the period) + (Any income received during the period of ownership of the investment asset, such as dividends) - (Size making investments)) / (size of investment undertaken)
Conclusions and Recommendations. Pros and Cons of ROI
ROI is one of the most intuitive and the most commonly used indicator to assess the effectiveness or efficiency of investment business from the point of view of the investor. It is clear to almost all users of financial statements, even without special training. The concept allows a clear ROI on clear principles and to make management decisions. Therefore, in the business - is one of the most popular indicators. Also , specialists in information technology and software implementation using ROI as a tool to assess the feasibility of a particular software product.
In addition, ROI can be used as a tool in estimating the initial investments. By calculating the ratio ROI, you can associate it with a yield of cash invested in alternative projects , or even a bank deposit . Therefore, with the help of ROI you can weed out projects that merit further attention - to put it simply, it is impractical.
Despite all the advantages described above, ROI has certain disadvantages.
Calculating ROI loses sight of the current value of money and the risks associated with the investment. That is not taken into account the fact that the cash or other benefits, say a year, not the same as that obtained at the moment - the money it would be possible to put , for example, a deposit and by the end of the year is to get a higher amount. That is a dollar earned today is worth more than a dollar earned tomorrow. If we add to this assessment also risks as well as inflation expectations, it becomes quite clear possibility of serious errors in decision -making, if based only on ROI.
For simple evaluations of the effectiveness of investment risk and the present value of money (NPV) can be neglected. For investment managers (here I use the term manager in the right sense, as a leader, and not, as is commonly the former Soviet Union ) ROI without considering the risks and the present value of the project may lead to wrong decisions taken .
At various levels of risk, projects in which estimation was used measure ROI, should be further revalued. ROI value of the project with a higher risk should be reduced proportionately. These techniques are investigated in detail in the course of risk management.
The methodological problem of compatibility ratings ROI probably has already been noted by you alone - a single "canonical" index formula is virtually absent. Moreover, in view of these earlier "innate" deficiencies ROI, constantly "invented" all the new interpretation - so that the values obtained with different formulas can be methodologically inconsistent. This should be kept in mind when comparing the figures obtained from various sources.
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- Internal Rate of Return
Analysis of IRR
Internal rate of return for financial instruments is the interest rate at which the present value of the future stream of payments of the financial asset is equal to its market price. Thus defined, the internal rate of return is the internal rate of return on investments in the financial point of time.
A - value of the bond;
P - the current market price of the bond;
f - annual coupon rate;
T (in years) - term to maturity of the bond.
IRR determines the maximum cost of capital employed, in which the investment project is profitable. In another statement, this is the average return on invested capital as provided by the investment project, i.e. the effectiveness of capital investment in the project is equal to the efficiency of investment under the IRR interest in any financial instrument with a uniform income.
IRR is calculated as the value of the discount rate at which NPV = 0. As a rule, the values of IRR are either graphical methods (plotted on the NPV discount rate), or by using specialized software.
Conclusions and Recommendations. Pros and Cons of IRR
- A relative measure.
- Comparable with the yield securities and bank interest.
- Takes into account the time value of money.
- Independent of the discount rate.
- The formula for calculating IRR has no intelligible definition.
- IRR shows the same value in the case when we take the credit, and when we give a loan.
- The project can have multiple values IRR (wherein all values may be inadequate), or may not be at all. This feature is related to the mathematical method of calculating the IRR.
- NPV and IRR may show different results in mutually exclusive projects, even if the same amount of investment.
- Cannot account for changes over time in discount rates.
- Since the IRR is the rate of reinvestment, the high value of IRR small change in the term structure of cash flow results in a significant change in the IRR.
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