Question

If we have several investment choices that have the same ROI, which is the most interesting to choose? Explain the types of items along with examples

Answer 1

Answer-

The Return on Investment ( ROI ) = ( Net pofit / Total Investment ) x 100

The investment choices with same ROIs means that the percentage of Net profit generated for the total investment is same. This means that Net profit and Total invesments may differ substantially for each investment and hence these investments value addition to the company may differ.

The various methods that can be used to choose the investments in case of same ROIs are

1) Net present value (NPV)

The investments that should be chosen must have higher Net present value ( NPV ) which will add value to the company and shareholder value due to incease in stock price.

NPV is the addition of present value of cash flows that are obtained from discounting less the initial investment.

NPV = - Initial investment + CF1 / ( 1+r) + CF2 / (1+r)2  + CF3 / (1+r)3 + ---

CF1 --- cash flow in year 1
CF2 --- cash flow in year 2
r = required rate of return or discount rate.

The NPV of a project with $ 200 can add more value than the project with NPV of $ 100.

2) Payback period

The payback period is the time required for the investment to recover the initial investment and the profits acheived thereafter.

The projects wih similar ROI can be distinguished by payback period. The lower the payback period the more desirable it is as the initial investment is recovered earlier.

The project with a payback period of 3 years is more preferable with the payback period of 4 years.

The Inernal Rate of Return (IRR) cannot be used as the IRR can be positive but if it's less than WACC or Cost of capital then the returns can be negative.