EFFICIENCY OF INVESTMENT PROJECTS MEASURED THROUGH STANDARD METHODS

Author: Institution: Published:

Jure Smajo, dipl. oec. VP Minerva ECNSI Zadar, 2009.

Abstract
Investment project is a decision or a venture which requires engagement of certain resources. When setting out an investment project a company or an individual faces various risks. Every investment is characterized by two components: cash flows and time period within they are conducted. It is necessary to establish project reports for that matter which must be as accurate as possible. Cash flow of the project is the composition of cash inflows or outflows. It gives a dynamic picture of the ultimate changes in cash resulting from the combined decisions made during a given period. Time value of money is the key concept of investment or savings. When establishing accounts for a long term investment, a discount rate is the measure of time value of money and it has extreme influence on the valuation results. The net difference of the present costs and benefits is the net present worth. Internal rate of return is a discount rate which reduces the net present value of the investment to 0. Payback period is a count of time necessary for a project to pay off for itself. Profitability index includes dividing total cash inflow and outflow. Annuity method describes the yearly costs of the project based on adapting the discounted cash flows to an annual level.

Key words: investment, valuation, project, cash flow, discount rate

Table of contents
1. Introduction ............................................................................................................................ 3 2. Investment information necessary for the valuation .............................................................. 4 2.1. Cash flow of the investment project ............................................................................... 4 2.2. Setting up a discount rate ......................................................................................... ......5 3. Net present value .................................................................................................................... 7 4. Internal rate of return.............................................................................................................. 8 5. Payback period ....................................................................................................................... 9 6. Discounted payback period ................................................................................................. 10 7. Profitability index ................................................................................................................. 11 8. Annuity method .................................................................................................................... 12 9. Conclusion ............................................................................................................................ 14 10. References .......................................................................................................................... 15

Index of tables
Table 1. Project cash flow statement, pg. 5 Table 2. WACC calculation, pg. 6 Table 3. Discount rates through periods, pg. 6 Table 4: Net present value, pg. 7 Table 5: Internal rate of return, pg. 8 Table 6: Payback period, pg. 9 Table 7: PBP assumption (years), pg. 9 Table 8: Discounted payback period, pg. 10 Table 9: DPBP assumption (years), pg. 10 Table 10: Profitability index, pg. 11 Table 11: PI calculation, pg. 11 Table 12: Equivalent annuity, pg. 12 Table 13: Annuity comparison, pg. 13

1. Introduction
An investment project can be defined as a decision or venture which requires engagement of certain resources. When setting out on an investment project a company or an individual faces various risks. Some of them are associated to external factors like business cycles, interest rates, political, legal, ecological factors etc., while others are related to internal factors including economic strength of the entrepreneur, experience, human potential quality and know-how for example. Although many non-numerical factors can be used to support the investor's claims about the efficiency and bright perspective of a certain investment, a complete project valuation has to include standard tools of financial analysis. The key for giving project a positive rating is that the benefits of it outmatch its costs. Methods that use discounting of cash flows in order to support management decisions are important at least as a mean of eliminating the non profitable project if the ratios show negative. Secondly, investment project quantitative valuation can be used in comparing two or more investments and deciding which is the optimal for the investor. Within a certain investment calculations can be made on questions of capital structure, operational costs, expected revenues etc. Final decision is always made by managers, but the quality of the decision support material may often be a key parameter of the decision. This text is a review of methods and techniques for analyzing an investment from the stand of the investor. All of them are based on cash flows and the most of them insist on discounting future cash flows on todays level. Taking into consideration the long-term nature of investment projects (from 3 or 5 to over 20 years), it seams more than reasonable to include discounting into the procedure. Methods presented here include net present value and the internal rate of return as flagships of investment valuations, but also some popular methods developed to supplement them in the best interest of the management and their decision making process.

2. Investment information necessary for the valuation

Every investment is characterized by two components: cash flows and time period within which they take place as a financial event. It is necessary to establish project reports for that matter which must be as accurate as possible. This is because the valuation outputs equally depend on reliability of the numbers presented in the cost manager reports, revenue predictions and on the value selected to be the discount rate in the calculations. High importance of these factors makes them an inevitable choice in fulfilling this chapter as the groundwork for all the investment analysis methods presented later on.

2.1. Cash flow of the investment project

Cash flow of the project is the composition of cash inflows and outflows. The statement that captures both current operating results and the accompanying changes in the balance sheet is the cash flow statement, statement of cash flows, or funds flow statement. It gives us a dynamic picture of the ultimate changes in cash resulting from the combined decisions made during a given period (Helfert, 2001). The statement is made of cash inflows which imply flow of funds into the project and outflows of funds out of the project. For a long term project cash inflows are actually income made by doing business (plus the residual value of the project at its conclusion), while outflows are made of cost of initial investment (investment made to initiate project business) and project operating costs. A good project team faces an imperative to estimate long term cash inflows and outflows. Presuming that an investment project has a goal of delivering a certain product or a service, or more of them, it is easy to identify both sides of the report. Inflow side then can be specified as quantity sold times price per product/ service, all of this allocated through the project period. Outflow is compounded of two parties as stated before: initial investment and operating costs. First of them are funds necessary to put the project into action, to make it operational. Purchasing the fixed assets, for example, or costs of getting funds required by the project are activities recognized as initial investment. Second of them are understood as costs of activities that keep the project going which can be costs of material, energy, salaries, interest, profit tax etc. When the team has a strong belief that this issue is solved by their best knowledge, it is time to pick out an appropriate discount rate. Example cash flow: As an example, an imaginary cash flow is shown in this part. Every chapter (explaining the valuation methods) will include a practical calculation for better understanding. This project is based on ten year prognosis in which there are two years of investment and another eight years of operation. In the years of operation (2-9) a certain profit is made as can be seen in net cash flow. Further through the review all of the methods are engaged in detailed estimation of imaginary projects quality and profitability.

Table 1. Project cash flow statement

PROJECT CASH FLOW STATEMENT Period 0 1 2 3 4 5 6 7 8 9 Inflow 0 0 27.300 38.400 49.200 50.800 51.200 52.100 52.100 52.100 Outflow 50.000 120.000 10.800 13.100 14.500 14.700 14.800 14.800 14.800 14.800 Net cash 16.500 25.300 34.700 36.100 36.400 37.300 37.300 37.300 50.000 120.000 flow

Authors example

2.2. Setting up a discount rate

Time value of money is the key concept of investments or savings. When establishing accounts for a long term investment, a discount rate is the measure of time value of money and it has extreme influence on the valuation results. To define a discount rate by weighted average cost of capital the financial manager must have all the necessary inputs. One of them is the capital structure of the project, which means share of equity (own funds) in the total budget. Other is expected rate of return on equity plus the requested rate of return on loan or other external source of financing. The WACC method is calculated by using this formula (Vidui, 2002):

WE share of equity in total budget WD share of debt in total budget kE expected return on equity kD requested interested rate on debt Calculated value is accepted as a relevant project discount rate, and with respect to time value concept, every future cash flow is discounted on todays value depending on the year of the project in which it is expected. This is done by the following formula: rn = (1 + d/100)n rn discount rate for cash flow in the n-th period d calculated discount rate per year (WACC) n number of periods Higher discount rate means higher risk, and project with higher risk consequently has lower NPV. A possible situation is different discount rates for different periods, which is closer to reality.

Example WACC and discount rate Table 2. WACC calculation

WEIGHTED AVERAGE COST OF CAPITAL ke kd we wd t WACC (discount rate) 5,800 9,300 0,350 0,650 0,200 6,866

Authors example In this example the investor insists on 5,8% return on the investment. This parameter is chosen by investors free will and can be based on opportunity rate of return like for example return on government or corporate bonds, return on a comparable project or on a bank deposit. In that way the investor sets up the discount rate at the high enough level to fulfill his profit expectations. Requested interest rate (9,3%) is specified by the creditor and cant be changed. The final number depends also on investment structure. If the investor can participate with more of his own (cheaper) funds, the WACC shall be lower respectively. The characteristic of the discount rate (d) is its exponential growth through periods. The table below shows the growth rate for our project. Table 3. Discount rates through periods
Period Discount rate cumulative 0 1,000 DISCOUNT RATE THROUGH PERIODS 1 2 3 4 5 6 1,069 1,142 1,220 1,304 1,394 1,489 7 1,592 8 1,701 9 1,818

Authors example

3. Net present value

One of the key methods used in investment project valuation is net present value (NPV), an analytical tool which decides whether is a project profitable or not after all the future cash flows decreased for initial and operational costs are discounted on todays level. In other words, the net difference of the present costs and benefits is the net present worth (Ardalan, 2000). NPV is calculated by using the following formula: Net cash flow in n-th period NPVn = Discount rate cumulative (n) An investment project is acceptable if its net present value is 0 or higher while if below 0 should be rejected without further consideration.

Example NPV The chosen cash flow has to be discounted for the chosen discount rate. The results are defined as discounted cash flows. In the fifth row of the table discounted cash flows are shown by periods. Sum of all of these values is the NPV. Table 4: Net present value
Period Net cash flow Discount rate cumulative 0 50.000 1,000 1 120.000 1,069 112.290 NET PRESENT VALUE 2 3 4 5 16.500 25.300 34.700 36.100 6 36.400 7 37.300 8 37.300 9 37.300

1,142

1,220

1,304

1,394

1,489

1,592

1,701

1,818

Discounted cash flow 50.000

14.448

20.730

26.605

25.901

24.438

23.433

21.928

20.519

Authors example After adding up discounted cash flows for projects total period the NPV is calculated at 15.712 units. Regarding its positive value, it is reasonable to conclude that, as far as NPV goes, the project is acceptable.

4. Internal rate of return

The famous IRR method has a place right next to the net present value due to its importance to investors. Moreover, some managers even prefer it as a valuation method because of its direct comparability to the discount rate. The key element is to find a discount rate which reduces the net present value of the investment with 0. The rate is internal because it depends only on the cash flows of the investment; no external data is needed (DeFusco and oth.; 2007). It is practical to calculate IRR using a computer rather then calculating it by traditional methods of iteration and linear interpolation. The formula below clearly shows the meaning of the discount rate which is variable with a goal of equalizing the left side of the equation with 0.

Net cash flow in n-th period 0= Discount rate cumulative (n) For an investment project to be acceptable its IRR has to be higher than the selected discount rate- cost of capital.

Example IRR The discount rate must be adapted for the discounted cash flow to be 0 in sum. In the table that follows the sum is exactly 0, which is accomplished with the discount rate 8,91%. Table 5: Internal rate of return
8,912 Period 0 Net cash flow 50.000 Discount rate 1,000 cumulative Discounted cash flow 50.000 1 120.000 1,089 110.180 2 16.500 1,186 13.910 INTERNAL RATE OF RETURN 3 4 5 6 25.300 1,292 19.583 34.700 1,407 24.662 36.100 1,532 23.557 36.400 1,669 21.809 7 37.300 1,818 20.520 8 37.300 1,980 18.841 9 37.300 2,156 17.299

Authors example Taken into consideration that the average cost of capital is 6,87, it can be concluded that the IRR is more then 2 p.p. higher than WACC. That fact supports the decision of accepting the investment as a reasonable one.

5. Payback period
Payback period is a simple method which answers a simple question: how long will it take to pay off a project investment costs with its own returns? This is the time necessary for a project to pay off itself. Cumulative cash flow is easy to calculate simply by summing year to year cash flows until the sum overpasses 0. If the cash flow becomes positive within the reasonable (and preordered) period, the project can be accepted. If not, the project is rejected. To have a more precise result, a formula is used to define in which part of the period (for example in which month of the year) the project pays off for itself (Vidui, 2002): Cumulative cash flow at the start of the period PBP assumption = Number of periods before total payback + Cash flow in the period of coverage (payback) One of the key flaws of payback period method is that it doesnt take into consideration the time value of money. Instead it operates with regular cash flows and for that matter it is not representative enough. This method also ignores any cash inflows beyond the payback period (Meredith and Mantel, 2006.), which separates it further from NPV and IRR methods.

Example PBP Table 6: Payback period

PAYBACK PERIOD Period Net cash flow Cumulative cash flow 0 50.000 50.000 1 120.000 170.000 2 16.500 153.500 3 25.300 128.200 4 34.700 93.500 5 36.100 57.400 6 36.400 21.000 7 37.300 16.300 8 37.300 53.600 9 37.300 90.900

Authors example The payback period calculation shows that the project takes between 6 and 7 years to pay off. Following the assumption that the cash flow has a linear character, the calculation shows that the pay off time would be 6,56 years- close to 6 years and 7 months. Considering the 9 year deadline, the project qualifies as acceptable. Table 7: PBP assumption (years)
PBP ASSUMPTION (years) 6,56 Number of periods before total 6 payback Cumulative cash flow at the start 21.000 of the period Cash flow in the period of coverage (payback) 37.300

Authors example 9

6. Discounted payback period

The method that resolves PBPs key problem is discounted cash flow (DPBP), although this method also has a flaw of ignoring cash flows after the payback. Its characteristics are same as those of regular PBP, but by including the time value of money it becomes more accurate, even though usually project valuation gives better results when done without discounting. Thats because an ordinary project begins its life with outflows, and its inflows follow in the years to come. By discounting the cash flow, the inflows loose on value more than the outflows (which are closer to zero period), and so the project looks less attractive to creditors. That is probably the reason for which the regular PBP is more popular then the discounted PBP. Example DPBP Table 8: Discounted payback period
Period Net cash flow Discount rate cumulative Discounted cash flow Cumulative cash flow 0 50.000 1,000 50.000 50.000 1 120.000 1,069 112.290 162.290 DISCOUNTED PAYBACK PERIOD 2 3 4 5 16.500 1,142 14.448 147.842 25.300 1,220 20.730 127.112 34.700 1,304 26.605 100.507 36.100 1,394 25.901 74.606 6 36.400 1,489 24.438 50.168 7 37.300 1,592 23.433 26.735 8 37.300 1,701 21.928 -4.807 9 37.300 1,818 20.519 15.712

Authors example The discounted payback period calculation shows that the project takes between 8 and 9 years to pay off. Following the assumption that the discounted cash flow has a linear character, the calculation shows that the pay off time would be 8,23 years- close to 8 years and 3 months. Considering the 9 year deadline, the project qualifies as acceptable even though the result was far better without discounting. Table 9: DPBP assumption (years)
DPBP ASSUMPTION (years) Number of periods before total payback Cumulative discounted cash flow at the start of the period Discounted cash flow in the period of coverage (payback) 8,23 8 4.807 20.519

Authors example

10

7. Profitability index
Another method based on facing investment cash inflows and outflows in total is profitability index, also known as PI shortly. Its difference from the NPV is in the fact that NPV is calculated on decreasing the present value of inflows for the present value of outflows, while the PI is calculated by dividing the present value of inflows with the present value of outflows. The result must be 1 or higher if the project should be accepted, as seen in the formula an in the example later on. Total discounted inflow Profitability index = Total discounted outflow Example PI Table 10: Profitability index
Period Inflow Outflow Discount rate cumulative 0 0 50.000 1,000 1 0 120.000 1,069 0 112.290 PROFITABILITY INDEX 2 3 4 5 27.300 38.400 49.200 50.800 10.800 13.100 14.500 14.700 1,142 23.905 9.457 1,220 31.464 10.734 1,304 37.723 11.118 1,394 36.447 10.547 6 51.200 14.800 1,489 34.374 9.936 7 52.100 14.800 1,592 32.731 9.298 8 52.100 14.800 1,701 30.628 8.701 9 52.100 14.800 1,818 28.660 8.142

Discounted 0 inflow Discounted 50.000 outflow

Authors example Similar to NPV, the project cash flows are discounted to todays value. The results are total discounted inflows of 255.933 units, and total discounted outflows of 240.221 units. When dividing the first with the second variable, the result is 1,065, which is higher than 1 and makes an acceptable investment according to the PI valuation method. The project actually operates with a 6,5% profit margin. Table 11: PI calculation
PI CALCULATION Total discounted inflow Total discounted outflow PI 255.933 240.221 1,065

Authors example

11

8. Annuity method
This method describes the yearly costs of the project based on adapting the discounted cash flows on an annual level. This is accomplished by using the annuity factor and multiplying it with sum of discounted inflow on one side, and the sum of discounted outflow on the other. Annuity method is useful when comparing projects with different lifetimes. The formula for calculating the annuity factor is: (1+d/100)n x d af = (1+d/100)n - 1

Now it is necessary to calculate the inflow and the outflow annuity: AI = af * Total discounted inflow AO = af * Total discounted outflow Where n is the total period of the project. If the inflow annuity (AI) is higher than the outflow annuity (AO) the project has a bright future concerning the annuity method. AI > AO Example Annuity method Table 12: Equivalent annuity
Period Inflow Outflow Discount rate cumulative Discounted inflow Discounted outflow 0 0 50.000 1,000 0 50.000 ANNUITY METHOD 1 2 3 4 5 0 27.300 38.400 49.200 50.800 120.000 10.800 13.100 14.500 14.700 1,069 0 112.290 1,142 23.905 9.457 1,220 31.464 10.734 1,304 37.723 11.118 1,394 36.447 10.547 6 51.200 14.800 1,489 34.374 9.936 7 52.100 14.800 1,592 32.731 9.298 8 52.100 14.800 1,701 30.628 8.701 9 52.100 14.800 1,818 28.660 8.142

Authors example (1+0,06866)9 x 0,06866 af = = 0,153 (1+0,06866)9 - 1

After discounting the cash flows it becomes obvious that the inflows outnumber the outflows. Annualizing is useful when there are projects with different lifetimes to compare (which is the purpose of annuity method). Even though, the calculations are made in this single example. The final result shows that the project is acceptable, 39.059 units on the inflow side outmatch the 36,661 of units on the outflow side. 12

AI (39.059)> AO (36.661) Table 13: Annuity comparison

ANNUITY COMPARATION Total discounted inflow 255.933 Total discounted outflow 240.221 0,153 af AI AO 39.059 36.661

Authors example

13

9. Conclusion
This review gives an insight into some of the most popular methods of analysis in investment project capital budgeting. Above mentioned methods are generally simple and easy to use, but their value is based on quality of input data. In other words and respecting the famous garbage in, garbage out principle, outcomes of the valuation are no more then mathematical results based on the assumptions of two components- the cash flow and the discount rate. When building assumptions far into the future, an investor is faced with extreme risk of being wrong. For example, when calculating ten or twenty years in advance it is practically impossible to consider all the factors that might take place in the general or investment environment, yet even those which are specifically tied to the project itself. All of these factors have to be as precisely as possible incorporated in the cash flow and in the rate by which the cash flow discounting will be made. A good financial planner has to devote his full attention to this issue. After this problem is solved in the proper manner, the investment project analysis can begin. Team members (one or more of them) who are responsible for financial analysis of the investment can begin their calculation of efficiency which is usually built up of all or most of the methods presented in the review. Some additional calculations or indexes may be included depending on the choice of the financial analyst or the request of investor, but the methods presented here are standard in investment project valuation. Regarding the initial problem of input reliability and consequently valuation of these inputs through key methods, it is necessary to ensure an additional reserve in case of deviations. This reserve is primarily seen as a contingency fee on the project's total investment value. The fee can be set as a percentage increase in the investment value, for example adding 10 percent on the sum of outflows. In that way a certain safety measure is implemented in the project. Other successful way of dealing with risks is classic sensitivity analysis which includes building case scenarios. Changing input elements like lowering cash inflows or raising outflows and discount rate can produce the foundation for worst case scenario possible for the project. This situation would be the bottom line and if the investment project would pass the efficiency test in the worst case scenario, there would be no problem in accepting the project as a desirable investment solution. As a result of here described efforts the project team would get a reliable prognosis on which they could lean on while planning project activities and afterwards when the realization of the project commences.

14

10. References
Ardalan, A. (2000); Economic and Financial Analysis for Engineering and Project Management; Technomic, Lancaster (pg. 20) DeFusco, R. A.; McLeavey, D. W.; Pinto, J. E.; Runkle, D. E. (2007); Quantitative investment analysis; CFA institute; Wiley & Sons, New Jersey (pg. 60) Helfert, E. A. (2001); Financial analysis: Tools and techniques, a guide for managers; McGraw-Hill, New York (pg. 42-43) Meredith, J. R.; Mantel, S. J. (2006); Project management; a managerial approach; Wiley & Sons, New Jersey (pg. 50) Vidui, Lj. (2002); Financijski menadment; RRiF, Zagreb (pg. 262, 282)

15