The balance of an investment project at a specific moment is the capitalized sum of the net cash flows derived from that project up to that moment, using the IRR of the project as the capitalization rate .
The concept of balance will allow us to know if an investment is pure or mixed . Thanks to the balance we know that in all pure investments the IRR is consistent, that is, it makes economic sense. On the other hand, in mixed investments the expression of the IRR is not consistent (profitability depends on the cost of capital of the company).
Interpretation of the balance of an investment project at a time t (St)
- St (r) <0The project is indebted to the investor. So far, a lower than expected return has been generated. It is still expected to receive money from the investment.
- St (r)> 0The investor is indebted to the project, because so far t has generated more profitability than originally expected.
- St (r) = 0At that time the account between the project and the investor is settled. In simple investments it always happens at the end of the project.
Example of the balance of an investment project
To facilitate the understanding of the balance we are going to give the example of a simple investment. If the cash flows are:
The IRR of the project is 8%.
The balance of the project in year 0 is -1000.
The balance of the project in year 1 is -876.35. This is -1000 (1 + 0.08) +200.
The balance of the project in year 2 is -743.25. This is -876.35 (1 + 0.08) +200.
The balance of the project in year 3 is zero. This is -743.25 (1 + 0.08) +800.
All project balances are negative or zero, therefore the investment is pure