Investment criteria

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Investment criteria

In the previous publication, we considered the TOP-20 phrases that cannot be pronounced during negotiations with the investor. However, the question remains open: “What exactly, first of all, does the investor want to hear, considering this or that project, communicating with the initiator of the investment project?”
The main mistake of almost any initiator of an investment project is that, hiding behind the colorful presentation design, they are trying to “splurge” a potential partner. But no one is considering or taking seriously beautiful pictures for a long time. The investor does not need them. Any investor does not look at the proposed project from the point of view of the design of the presentation or beautiful fairy tales about the global prospects of the project, but from the point of view of evaluating the effectiveness of the idea, its shortcomings and advantages.
Alfa Resonance Capital suggests considering the main criteria and methods for evaluating the effectiveness of investment projects that use real investment structures in order to formulate an initial decision on financing an investment idea.
The financial and economic evaluation of investment projects is central to the process of justifying and selecting possible investment options in operations with real assets. To a large extent, it is based on project analysis. The purpose of project analysis is to determine the result (value) of the project. Typically, the following expression applies:
Project Result = Project Price – Project Costs
Predictive assessment of the project is a rather difficult task, which is confirmed by a number of factors:
  • investment expenses can be made either on a one-time basis or for a long time;
  • the period for achieving the results of the implementation of the investment project may be greater than or equal to the estimated period;
  • long-term operations lead to increased uncertainty in assessing all aspects of investment, that is, to an increase in investment risk.
The effectiveness of the investment project is characterized by a system of indicators reflecting the ratio of costs and results depending on the interests of its participants.

Assessment of the overall project efficiency for the investor. Investment projects can be both commercial and non-commercial. Even with non-commercial projects there are opportunities spent, and there are opportunities received.
The difference between investment projects and the operating activities of the organization is that the costs intended for a single acquisition of some opportunities do not apply to investments. In this case, the investor is a person who invests his opportunities for reuse, forcing them to work to create new opportunities.
If for commercial projects there are ways to assess their effectiveness, then how to evaluate the effectiveness of non-profit projects? Efficiency in the general case is understood as the degree of conformity of the goal. The goal should be set accurately, in detail and allow only a definite answer – whether it is achieved or not. At the same time, you can achieve the goal in different ways, and each path has its own costs.
To decide on the implementation of a commercial project, an assessment of its economic efficiency is carried out. In the case of a non-profit project, if it is decided to achieve the goal, the choice is to determine the most effective way. At the same time, non-financial criteria should take precedence over financial indicators. But at the same time, the goal should be achieved in the least expensive way.
Also, when evaluating a nonprofit project:
  • the investor’s resilience to project implementation should be taken into account – will the investor withstand the implementation of the project;
  • when determining alternative options of equal quality, the cheapest option is usually chosen;
  • It is advisable to plan the movement of costs (investments) in dynamics in order to calculate forces in advance, provide for a deficit and take care of attracting additional resources, if necessary.

Assessment of external effects of the project. The second nuance of project evaluation is that the project will have value not only in the eyes of the investor. For example, investing in the education of certain people will bring benefits not to themselves, but to the community as a whole, which then used the discoveries and inventions of scientists for their needs.
Investment projects of commercial organizations, along with commercial significance, also have the following effects:
  1. The social effect is evaluated by the use of the project for society, or living around the place of implementation of the plan, or working on the project, and consists of:
  • in raising salaries;
  • in the development of infrastructure and other opportunities for the population around the project site.
  1. The tax effect is estimated by the volume of projected tax revenues to budgets of all levels (municipal, regional, federal).
  2. The budgetary effect is evaluated if the project is fully or partially financed from budgetary funds. It is determined how much money after the implementation of the project will be returned through tax payments for a certain period of time.
  3. The environmental effect occurs if the project somehow affects the environmental situation.
All the results of the plan for the other parties are significant, since the company and the project are surrounded by the community, people, state, nature. If the environment improves from the plan, then it is probably better for a commercial organization that implements an investment project, since everything is interconnected in the world.
General approaches to determining the effectiveness of investment projects. The basis for making investment decisions is the assessment of the economic efficiency of investments. A market economy requires taking into account the impact on the efficiency of investment activities of environmental factors and the time factor, which do not find a full assessment in the calculation of these indicators.
Consider the main methods for assessing the effectiveness of investment projects in more detail and find out their main advantages and disadvantages.

Static evaluation methods. Payback period for investments (Payback period, PP). The most common static indicator for evaluating investment projects is the payback period (PP).
The payback period is the time period from the moment the investment project is launched until the facility is put into operation, when income from current activities becomes equal to the initial investment (capital costs and operating costs).
This indicator gives an answer to the question: when will the full return on invested capital occur? The economic meaning of the indicator is to determine the period for which the investor can return the invested capital.
As a measure, the PP criterion is simple and easy to understand. However, it has its drawbacks, which we will examine in more detail when analyzing the discounted payback period (DPP), since these drawbacks relate to both static and dynamic indicators of the payback period. The main disadvantage of this ratio is that it does not take into account the cost of cash over time, that is, it does not distinguish between projects with the same balance of income stream, but with a different distribution by year.
The coefficient of investment efficiency (Account rate of return, ARR). The coefficient of investment efficiency or the accounting rate of return or the profitability ratio of the project. There are several algorithms for calculating this indicator.
This calculation indicator is based on the ratio of the average annual amount of profit (minus deductions to the budget) from the project for the period to the average investment.

Dynamic assessment methods. Net present value (NPV). The NPV value is calculated as the difference between the discounted cash flows of income and expenses incurred in the course of the investment for the forecast period. The essence of the criterion is to compare the present value of future cash receipts from the implementation of the project with the investment costs necessary for its implementation.
The conditions for making an investment decision based on this criterion are as follows:
if NPV > 0, then the project should be adopted;
if NPV < 0, then the project should not be accepted;
if NPV = 0, then the adoption of the project will bring neither profit nor loss.
The basis of this method is the following of the main target setting determined by the investor – maximizing its final state or increasing the value of a commercial organization. Following this target setting is one of the conditions for a comparative assessment of investments based on this criterion.
With all the advantages of this indicator, it has significant disadvantages. Due to the difficulty and ambiguity of forecasting and generating cash flow from investments, as well as the problem of choosing a discount rate, there may be a risk of underestimating the risk of the project.

Profitability Index (PI). The profitability index is a relative indicator of the effectiveness of an investment project and characterizes the level of income per unit of cost, that is, the efficiency of investments – the higher the value of this indicator, the higher the return on the monetary unit invested in this project.
This indicator should be preferred when completing the investment portfolio in order to maximize the total NPV.
The conditions for the adoption of the project for this investment criterion are as follows:
if PI > 1, then the project should be accepted;
if PI < 1, then the project should be rejected;
if PI = 1, the project is neither profitable nor unprofitable. It is easy to see that when evaluating projects that have the same initial investment, the PI criterion is fully consistent with the NPV criterion.
In other words, this index shows how much profit an investor will receive from each separately invested dollar.

Internal rate of return (IRR). The meaning of calculating the internal rate of return when analyzing the effectiveness of an investment project is as follows: IRR shows the maximum allowable relative level of expenses that can be associated with this project. For example, if the project is fully funded by a commercial bank loan, the IRR value indicates the upper limit of the acceptable level of the bank interest rate, the excess of which makes the project unprofitable.
The economic meaning of this indicator is as follows: the company can make any investment decisions, the level of profitability of which is not lower than the current value of the CC indicator (price of the source of funds for this project). It is with him that the IRR calculated for a specific project is compared, while the relationship between them is as follows:
if IRR > CC, then the project should be accepted;
if IRR < CC, then the project should be rejected;
if IRR = CC, then the project is neither profitable nor unprofitable.
The advantage of the internal rate of return method in relation to the method of net present value is the possibility of its interpretation. It characterizes the accrual of interest on capital spent (return on capital spent).
The criteria NPV, IRR and PI, which are most often used in investment analysis, are actually different versions of the same concept, and therefore their results are related to each other. Thus, we can expect the following mathematical relationships to be completed for one project:
if NPV > 0, then IRR > CC (r); PI> 1;
if NPV < 0, then IRR < CC (r); PI <1;
if NPV = 0, then IRR = CC (r); PI = 1.
There are techniques that adjust the IRR method for use in a particular non-standard situation. One of these methods is the modified internal rate of return method (MIRR).

Modified internal rate of return (MIRR). The modified rate of return (MIRR) eliminates a significant shortcoming of the internal rate of return for a project that arises in the event of a repeated outflow of funds. An example of such a repeated outflow is an installment purchase or construction of a property that takes several years. The main difference of this method is that reinvestment is carried out at a risk-free rate, the value of which is determined based on the analysis of the financial market.
In practice, this may be the yield on a term deposit in foreign currency offered by a particular bank. In each case, the analyst determines the risk-free rate individually, but, as a rule, its level is relatively low.
Thus, discounting costs at a risk-free rate makes it possible to calculate their total current value, the value of which allows a more objective assessment of the rate of return on investments, and is a more correct method in the case of investment decisions with irrelevant (extraordinary) cash flows.

Discounted payback period (DPP). The discounted payback period (DPP) eliminates the drawback of the static method of payback period and takes into account the value of money over time.
Obviously, in the case of discounting, the payback period increases, that is, always DPP> PP.
The simplest calculations show that such a technique, given the low discount rate typical of countries with stable economies, improves the result by an imperceptible amount, but for a significantly higher discount rate typical of a developing economy, this gives a significant change in the estimated payback period. In other words, a project that is eligible for PP may not be eligible for DPP.
When using the PP and DPP criteria in evaluating investment projects, decisions can be made based on the following conditions:
  1. the project is accepted if the payback takes place;
  2. The project is accepted only if the payback period does not exceed the deadline set for a particular company.
One of the significant drawbacks of this criterion is that, unlike the NPV indicator, it does not have the additivity property. In this regard, when considering a combination of projects with this indicator, you must be careful when considering this property.
In the general case, the determination of the payback period is auxiliary in relation to the net present value of the project or the internal rate of return. In addition, the disadvantage of such an indicator as the payback period is that it does not take into account subsequent cash inflows, and therefore can serve as an incorrect criterion for the attractiveness of the project.

Being in the process of giving birth to an investment idea, any initiator (or entrepreneur) is obliged to realize, accept and understand one indisputable truth: preparation of an investment project is a complex process based not on building beautiful pictures and diagrams, but on mathematical and actuarial analysis, risk analysis and prospects, analysis of trial and error, analysis of the viability of the idea, analysis of market conditions and the conformity of the project to this situation and, most importantly, the most critical attitude to oneself.

Attention! In the context of the new economic realities associated with the spread of COVID-19, Alfa Resonance Capital is starting to form a new and additional investment portfolio. The offer is limited. For all questions: office@arcgroupltd.eu

 

 

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