Conceptual bases of investment analysis and methods for assessing...

Conceptual fundamentals of investment analysis and methods for assessing the effectiveness of investment activities

The investment activity of a commercial organization is multifaceted, which is reflected in the structure of its non-current assets. In assessing the effectiveness of the investment activity of an enterprise, it is first of all necessary to proceed from the nature of the overall strategy for its development, since an adequate investment policy, of which the investment budget is a financial security, is an instrument for its implementation. The latter is a well-defined portfolio of investment projects that differ in the degree of innovation, the scale of the attracted capital, life expectancy, the level of risks and profitability. Therefore, a methodical apparatus is needed to justify the choice of management decisions in the field of investment.

The methodology of investment analysis includes several key concepts, the applied aspects of which have formed a modern analytical tool in this area. The main ones are: the concept of changing the value of money over time; the concept of risk-return ratio; the concept of cash flows; the concept of alternative return on investments.

Practical application of the concept of changing the value of money over time in innovation and investment analysis:

• assumes the understanding of capital as a financial resource and causes the need to calculate interest income on invested capital;

• requires the quantification of the degree of dependence of return on investments on the time factor and the level of risks;

• is based on discounting procedures.

The concept of the relationship between risk and return on investment shows the fundamental principles of investing: the level of profitability should be higher in projects with higher risks and it may be lower for investments with relatively low risks; any investment has risks. Practical implementation of the essence of this concept finds its expression in specific methods for identifying and assessing the level of project risks; the need to choose how to take into account the level of investment risks in assessing the return on investment; justification of the cost of attracted financing and the formation of the capital budget.

Using the concept of cash flows is of fundamental importance for assessing the real level:

• The need for financing innovation-investment programs;

• financial viability (profitability) of specific investment projects.

In order to understand the essence of the concept of cash flows and the rules for the practical use of procedures for the direct calculation of their value, it is necessary to clearly distinguish between accounting data on revenues from the sale of goods (products, work, services), the costs of their production and marketing, the profit from sales and similar indicators, calculated on the basis of cash flows (Table 7.2).

Table 7.2. Differences in the definition of profitability

Metric

Reflection principles

in the accounting system

According to the cash flow concept

Revenues from sales of products

The principle of charging Using non-monetary forms of payment

Volume of cash receipts

Costs

The principle of charging Using non-monetary forms of settlements and depreciation is not a payment

Volume of payments in cash

Financial result

Profit

Net cash flow

The main differences are that "incomes in each of the analyzed periods according to the concept of cash flows are only those that arrived at the accounts and in the cash department of the enterprise, and costs are recognized only respectively paid in cash. Hence the differences in the financial result.

For investment analysis in accordance with the concept of changing the value of money in time, it is the timeframes for income receipt and payment of costs that are crucial, since the discount coefficients differ in magnitude not only depending on the rates chosen, but also on the period to which they relate.

The concept of alternative return on investments means the need to determine the projected profitability of all available investment opportunities (for example, foam, real estate, precious metals, etc.) and ranking them according to the level of profitability from maximum to minimum. The latter, in fact, is of practical importance for determining the lower permissible return on capital for planned investment projects. In other words, investments in the development of the core activities of enterprises with yields below the minimum of alternative opportunities are economically impractical and the base discount rate for project evaluation should be correspondingly higher.

Thus, the following basic principles are used as the basis for assessing the effectiveness of investment projects (IP).

1. Consider the project throughout its life cycle (billing period).

2. Modeling of cash flows, including all project-related cash flows (positive and negative) for the settlement period.

3. Comparability of comparison conditions for various projects (project options);

4. Principle of positivity and maximum effect. In order for the investment project to be considered effective from the investor's point of view, it is necessary that the effect of the project implementation be positive; when comparing alternative PIs, preference should be given to the project with the greatest effect value.

5. Accounting for the time factor. When assessing the effectiveness of a project, various aspects of the time factor should be taken into account, including the dynamic nature of the project's parameters and its economic environment, the time lag between production (production) or the receipt of resources and their payment, the unevenness of costs and results at different times.

6. Accounting for only upcoming costs and revenues. When calculating performance indicators, only the payments and receipts that are coming into effect during the implementation of the project, including the costs associated with attracting previously created production assets, as well as the impending losses directly caused by the implementation of the project, should be taken into account. Previously created resources used by the project are estimated not with the cost of creating them, but with an opportunity cost reflecting the maximum value of the lost profit associated with their best possible alternative use.

7. Accounting for the most significant consequences of the project. When determining the effectiveness of an investment project, all the most significant consequences of its implementation, both directly financial and economic, and of a social nature must be taken into account.

8. Accounting for the presence of different project participants, the discrepancy of their interests and different estimates of the cost of capital, expressed in individual values ​​of the discount rate.

9. Multi-stage evaluation. At various stages of the development and implementation of the project, its effectiveness is determined anew, with varying depth of elaboration.

10. Accounting for the impact of inflation (accounting for changes in prices for different types of products and resources during the project period).

11. Accounting for the impact of uncertainty and risks accompanying project implementation.

From a practical point of view, the most important thing about the methods of assessing the attractiveness of a PI is the need to understand:

• requirements for the selection of methods for assessing the financial viability of investment projects, depending on their purpose and the nature of the benefits obtained; should take into account the types and conditions of obtaining as a result of the implementation of investment projects benefits not only financial, but also economic, social, environmental nature;

• Differences between static and dynamic methods for assessing the effectiveness of capital investment, the possible areas of their application;

• Methods of calculation, economic sense, advantages and disadvantages of dynamic (financial) methods for estimating the profitability of investment projects - net reduced, or discounted, cost of projects (NPV, NPV), their internal level of profitability (IRR, VID), profitability index of projects (WG), indicators of the payback period of investments;

• rules for selecting projects for financing on the basis of criteria for their net present value of the internal level of the project's profitability, profitability index and the payback period of investments.

It should be noted a noticeable narrowing of the scope of the application of static methods due to scientific and technological progress, as a result of which cases of the introduction of production equipment identical to the current one become quite rare. At the same time, it is necessary to remember the principle of comparing the costs of analysis and evaluation (including time) with the results obtained, when the preparation of more accurate and complete information does not entail a fundamental change in the priority of certain investment decisions or when the choice between variants is obvious without the use of complex calculations.

Dynamic (financial) methods for assessing the profitability of investment projects have been developed with the aim of eliminating the drawbacks inherent in static methods and meet modern requirements.

The net present value of the project (net present value, NPV) is the difference between the sum of discounted receipts and payments for the whole period of its life, which can be represented in the formalized form as follows:

where В, - income received in period 1 С1 - expenses paid in the period of 1 g - discount rate; & iquest; = 1,2, 3, 4, n - time periods of project implementation; n is the lifetime of the project.

The economic meaning of the project indicator is that it characterizes the increase (decrease) in the cost of capital of a commercial organization as a result of the implementation of an investment project with the projected values ​​of the cash flows generated by it and a given discount rate. Its advantages as a criterion for the selection of projects:

• takes into account the cash flows and profitability of the project for the entire period of its life;

• takes into account the change in the value of money over time;

• allows you to rank individual projects according to the degree of their profitability;

• is additive, i.e. will give an opportunity to summarize the benefits of the projects accepted for financing and thereby determine the profitability of the investment budget or the program from several projects as a whole.

If the net present value of the project is greater than zero (NDG & gt; 0), i.e. is a positive number, then it brings income in the amount of YNR from an economic point of view, it is expedient to finance it. In a situation where the net present value of the project is less than zero (#V & lt; 0) and is a negative number, then for financial reasons it should be rejected as unprofitable. Discounted payments generated by the project in such cases are not covered by the amount of its discounted receipts and the resulting loss will have to be covered by so-called cross-financing (cash proceeds from the main types of operating activities), which, naturally, reduces the profitability of sales and is unacceptable. >

If the net present value of the project is zero (L'RU = 0), the project yields interest on the invested capital equal to the discount rate. Numerous assertions in the domestic literature that when YYR = 0 the project is not profitable and unprofitable, are untenable. This is especially obvious when using the weighted average cost of financing as the discount rate (the most common option) and stems from the incorrect interpretation of the concept of changing the value of money over time.

The following problems should be attributed to the shortcomings of YDU projects:

• the discount rate must be chosen in advance and the yield is estimated at a given value; if mistakes are made in its justification, the decisions regarding the assessment of the profitability of the IP will be erroneous, and because of the long-term nature of such decisions and the associated large investments of capital, they are fraught with very serious negative consequences;

• Dependence on the size of the discount rate; Moreover, projects that are profitable at relatively low discount rates can be unprofitable at higher values; as a result, the position of projects in their ranked list changes;

• Shades differences in investment volumes and projects with the same IRU can have completely different investment needs.

Profitability index or "benefits-costs" ratio. " (profitability index, WG) is a modification of NPV and is determined by dividing net discounted flows over the operational period by the amount of discounted capital investments. It measures the value of the net present value of the project, formed for the period of operation of the facility, per unit of discounted capital investments; in other words, characterizes the level of return on the investment ruble.

The mathematical expression of the profitability index is derived from the net present value of the project. The size of the NPV can be represented as the difference between the sum of the net discounted flows received for the planned lifetime of the assets created within the framework of the project, and the value of the reduced amounts of capital investments disbursed during the investment phase:

where d is the period that completes the investment stage; & iquest;/+ 1 - the initial period of the operational phase.

This leads to a different possibility of modifying the project's MYR formula. In order to show the differences in the scale of investments of individual projects with equal or close values ​​of NDU, instead of subtracting, it is useful to find the relationship between two elements of formula (7.5) under the signs of the sum, i.e. determine the profitability index P1:

The economic meaning of the index of profitability of RI is that it characterizes the level of return on invested capital: the amount of discounted net proceeds generated for the planned life of the created objects and falling on the ruble of investments. The profitability index can take the values: P1 & gt; 1.0; PI = 1.0; P1 & lt; 1.0. It is obvious that for values ​​of РІ less than one unit, capital investments do not pay off. In projects with PI equal to one, the investment pays off in full, and the owners and investors receive a return on invested capital at the discount rate. From this it follows that investment projects with PI more than one are the most preferable and the higher the indicated index, the greater return is expected on invested capital.

The advantages of the profitability index as a criterion for selecting investment-attractive projects are as follows:

• takes into account the relative differences in investment needs;

• allows you to rank projects by the level of return on capital;

• takes into account the change in the value of money over time;

• Evaluates the profitability of the project for the entire period of its life.

As a modification of the NPV indicator, the profitability index, of course, has some of the same disadvantages. In particular, the discount rate has to be chosen in advance and the possible negative consequences are the same as for NPV. In addition, depending on whether we compare benefits and costs on a gross basis or after tax, we will get different results for the same project at the same discount rate. Finally, it is difficult to understand how, for example, P1 = 1.2 is better than P1 = 1.1.

The indicators of NPV and P1 projects characterize their profitability in absolute and relative terms, respectively, but at a given discount rate. It remains unclear, what is the maximum possible level of the estimated profitability of a particular project. The answer to this question is given by the internal rate of return (IRR) of the project, since it is he who characterizes the maximum or maximum possible level of interest income on invested capital.

The technique of calculating the IRR follows from the characteristic of the economic content of the zero value of the NPV of any project. As noted above, if the NPV of the project is equal to a bullet, then the expected interest income on the capital invested in it according to the concept of changing money over time is equal to the discount rate. Graphically this situation is illustrated in Fig. 7.2.

Graphical illustration of the IRR definition of the project

Fig. 7.2. Graphical illustration of the IRR definition of the project

Mathematically, the order of the IRR calculus can be illustrated by the following formula:

Equating the NPV of the project to zero with the expected values ​​of receipts and payments for the entire period of its life, we solve the above equation with respect to the discount rate (;), at which we obtain the desired level of IRR. He characterizes the investment attractiveness of projects from a different point of view than NPV and PI. In fact, we get an additional characteristic of the profitability of projects - the indicator is expressed in percentage form and, as a result, is comparable to the weighted average cost of their financing, which is of fundamental importance. Such comparisons allow determining under what conditions of financing the expected cash flows of a particular project will be sufficient. Hence, there are quite certain rules for selecting projects according to the IRR criterion, which form the following requirements for its level:

• IRR should be higher than the return on alternative investment opportunities;

• IRR should be above the average weighted cost of capital.

Regarding the latter, the question arises: how much should the IRR exceed the weighted average cost of capital? Foreign experience shows that, depending on the macroeconomic situation, the excess of IRR over the average weighted cost of capital varies from 5 to 15 percentage points.

The internal level of profitability of projects is also inherent in both advantages and disadvantages. To its merits follows, as already noted, attributed the possibilities:

• Comparison of project profitability with the cost of its financing;

• Ranking of projects by the level of IRR;

• accounting for changes in the value of money over time;

• Estimating the profitability of the project for the entire period of its life.

At the same time, IRR is not the best criterion for choosing between mutually exclusive projects. For non-standard cash flows, the project may have more than one IRR value, and the assumption that the generated cash flow can be reinvested at the internal rate of return is not always true.

The payback period is one of the oldest methods for evaluating the attractiveness of investment projects, although the methodology for its calculation has changed since the introduction of financial or dynamic analysis methods into the practice of investment activities. It is also determined on the basis of cumulative discounted cash flows. The consequences of these transformations are clearly visible in Fig. 7.3; as before, the payback period is the time period necessary to cover the initial capital investments. Its advantages: relatively simple calculations, as well as the fact that with its help it is possible to assess the investment risk to a certain extent. The disadvantages of this indicator include the following:

• does not take into account the cash flows generated by the project after the payback period;

• does not characterize the level of profitability of the project.

Graphic illustration of the payback period of investments

Fig. 7.3. Graphic illustration of the payback period of investments

Completing the topic of investment appraisal methods, it should be summarized: NPV, PI and IRR are key criteria for selecting financially viable projects, reflecting various aspects of their profitability, although they are not flawless. The rationale for making decisions on investments in the development of a commercial organization is not limited, as was noted when characterizing the conceptual foundations of investment analysis, by assessing their profitability.

The discounted pay-back period, DPP or DPBP is currently used as one of the risk assessment methods, but, of course, does not exhaust the entire arsenal of investment risk analysis tools. The variety and importance of the influence of the latter require careful analysis and special consideration, which is beyond the scope of this textbook.

Also We Can Offer!

Other services that we offer

If you don’t see the necessary subject, paper type, or topic in our list of available services and examples, don’t worry! We have a number of other academic disciplines to suit the needs of anyone who visits this website looking for help.

How to ...

We made your life easier with putting together a big number of articles and guidelines on how to plan and write different types of assignments (Essay, Research Paper, Dissertation etc)