Question

Dynamic methods of evaluation of the effectiveness of investments primarily focused on:

-nature of dynamic methods of investment evaluation and input parameters that are used

-strengths and weaknesses of dynamic methods of investment evaluation

-characteristics of “net present value“, “IR“ and “internal rate of return“ indicators

Answer 1

1.  Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project.

Formula

NPV = (Cash flows)/( 1+r)i

i- Initial Investment

Cash flows= Cash flows in the time period

r = Discount rate

i = time period

A positive net present value indicates that the projected earnings generated by a project or investment - in present dollars - exceeds the anticipated costs, also in present dollars. It is assumed that an investment with a positive NPV will be profitable, and an investment with a negative NPV will result in a net loss. This concept is the basis for the Net Present Value Rule, which dictates that only investments with positive NPV values should be considered.

Money in the present is worth more than the same amount in the future due to inflation and to earnings from alternative investments that could be made during the intervening time. In other words, a dollar earned in the future won’t be worth as much as one earned in the present. The discount rate element of the NPV formula is a way to account for this.

Advantages:

• NPV provides an unambiguous measure. It estimates wealth creation from the potential investment in today’s dollars, given the applied discount rate.
• NPV accounts for investment size. It works for comparing marginal forestry investments to multi-billion-dollar projects or acquisitions.
• NPV is straightforward to calculate (especially with a spreadsheet).
• NPV uses cash flows rather than net earnings (which includes non-cash items such as depreciation).
• NPV recognizes the time value of money (unlike cash-on-cash returns or simple payback period). For forestry investments, which tend to be long-term, this is critically and entirely appropriate.
• NPVs are additive. If you have multiple projects and excess capital, you can add up projects to get a sense of aggregate wealth creation from all investable projects.

Disadvantages:

• A discount rate must be selected. NPV also assumes the discount rate is the same over the life of the investment or project. Discount rates, like interest rates, can and do change year-to-year. Consider capitalization (“cap”) rates in commercial real estate. Benchmarks move. Opportunity costs change and differ across investors.
• NPV assumes you can accurately assess and predict future cash flows. While your crystal ball may prove infallible, mine has shown cracks at times.
• For some, it is an intuitively difficult concept to grasp.

2. Payback Period

The payback period refers to the amount of time it takes to recover the cost of an investment. Simply put, the payback period is the length of time an investment reaches a break-even point. The desirability of an investment is directly related to its payback period. Shorter paybacks mean more attractive investments.

The payback period is the cost of the investment divided by the annual cash flow. The shorter the payback, the more desirable the investment. Conversely, the longer the payback, the less desirable it is. For example, if solar panels cost $5,000 to install and the savings are $100 each month, it would take 4.2 years to reach the payback period.

Features of Payback period method

• Payback period is a simple calculation of time for the initial investment to return.
• It ignores the time value of money. All other techniques of capital budgeting consider the concept of time value of money. Time value of money means that a rupee today is more valuable than a rupee tomorrow. So other techniques discount the future inflows and arrive at discounted flows.
• It is used in combination with other techniques of capital budgeting. Owing to its simplicity the payback period cannot be the only technique used for deciding the project to be selected.

Advantages

1. It Is Simple
A significant percentage of companies use employees with different backgrounds to analyze capital projects which is not only biased but a difficult process to understand. On the other hand, payback method looks at the number of years which make it simple and easy to understand.

2. Offers Quick Evaluation
Determining which projects can generate fast returns is important to companies especially those with limited resources. Managers of such companies use this method to make a quick evaluation regarding projects with the small investment and short payback period.

Other benefits include:

• The term is universal hence can be understood by anyone.
• It shows the importance of considering liquidity when making investment decisions.
• It offers the shortest approach to calculating capital expenditure.

Disadvantages

1. Ignores Time Value of Money
The method ignores the time value of money. A project’s cash inflow might be irregular. Investments are usually long term and continue to generate income even long after they have paid back their initial start-up capital. However, if a project has a long payback period it gets overlooked.

Other disadvantages include:

• The method emphasizes on liquidity rather than profitability.
• Only cash returns within the period are considered.

3. Internal Rate of Return

The internal rate of return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments. The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. IRR calculations rely on the same formula as NPV does.

To calculate IRR using the formula, one would set NPV equal to zero and solve for the discount rate (r), which is the IRR. Because of the nature of the formula, however, IRR cannot be calculated analytically and must instead be calculated either through trial-and-error or using software programmed to calculate IRR.

Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake. IRR is uniform for investments of varying types and, as such, IRR can be used to rank multiple prospective projects on a relatively even basis. Assuming the costs of investment are equal among the various projects, the project with the highest IRR would probably be considered the best and be undertaken first.

IRR is sometimes referred to as "economic rate of return" or "discounted cash flow rate of return." The use of "internal" refers to the omission of external factors, such as the cost of capital or inflation, from the calculation.

Advantages

• This method is widely being used for its most attractive feature which is “Simplicity”. The tool gives a quick glance on the potential cash flow of the capital investment. It is also used for budgeting purpose.
• The tool considers the time value of money while assessing potentiality of capital investments.
• In IRR calculation, the required rate of return is not required to calculate the internal rate of interest.

Disadvantages

• The tool ignores the size of the project while comparing with other business projects. The cash flows are compared to the capital expenses which generates those cash flows. This can create huge problem while calculating IRR.
• The tool ignores future cost and reinvestment cost.
• While comparing the cash flow, when a project has negative cash flows in between positive cash flows, IRR equation will be solved with greater than one rate of return. Thereby getting trapped in multiple IRR.