Whether it is the creation of a new company, the launch of a new product, the development of a new product line, the acquisition of new machinery, or the opening of a new branch, the evaluation stage is a mandatory stage in the development of any investment project.
Evaluating an investment project mainly allows us to know if the project is profitable and, therefore, viable, what is its profitability and, if we have several investment projects as alternatives, to know which is the most profitable and, therefore, the most attractive.
However, knowing if an investment project is profitable and what is its profitability are not the only questions that are sought to be answered when evaluating an investment project, but also seek to answer other questions such as:
- What is the present value of the projected benefits of the project?
- How soon can the investment be recovered?
- How much do you have to sell to cover the costs associated with the project?
- How much does it have to sell for the project to start generating profits or profits?
- What is the relationship between the costs and benefits associated with the project?
To answer these and other questions, various financial tools are used such as the return on investment (ROI), the net present value (NPV), the internal rate of return (IRR), the period of recovery of the investment, the break-even point and cost-benefit ratio (B / C).
In this article we will show you how to evaluate an investment project through the use of the main financial tools that exist for this purpose.
Keep in mind that an investment project not only involves creating a new business , but also an investment that can be made in a going concern , such as developing a new product or acquiring new machinery.
In this article you will find:
- Return on investment (ROI)
- Net Present Value (NPV)
- Internal rate of return (IRR)
- Period of payback
- Breakeven
- Cost-benefit (B / C)
- Summary of results
- Final notes
Return on investment (ROI)
Due to its ease of use, the return on investment index (ROI) is one of the most used financial tools when evaluating an investment project.
ROI is an index that measures the relationship between projected net earnings and investment.
The ROI formula is:
| ROI = (Profit or Profit / Investment) x 100 |
If the ROI is greater than zero, the project is profitable (the higher the ROI, the greater the percentage of capital that will be recovered), and if it is less than or equal to zero, the project is not profitable, since if it is launched, would lose money invested.
For example, if an investment project has a total investment of $ 10,000, and a projected profit of $ 20,000, its ROI will be as follows:
ROI = (20000/10000) x 100
ROI = 200%
Conclusion : the project has a ROI of 200% with what we can affirm that it is profitable and offers a profitability of 200%.
Net Present Value (NPV)
The Net Present Value (NPV) is another financial tool that allows knowing the profitability of an investment project; but that unlike ROI takes into account the value of money over time, allowing a more accurate evaluation.
The NPV measures the profit that a project will have by discounting the amount of the investment at the present value of the total projected cash flow.
The NPV formula is:
| VAN = BNA – Investment |
Where the updated net profit (BNA) is the present value of the total projected cash flow, which has been updated through a discount rate corresponding to the expected minimum rate of return.
If the NPV is greater than zero, the project is profitable since the expected rate of return is met and an additional profit is also obtained, if it is equal to zero it is also profitable since the expected rate is met, and if it is less that zero is not profitable since the expected rate is not met and also invested money is lost.
For example, an investment project has an investment of US $ 10,000, and a projected cash flow of 5 years whose last line is as follows:
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| Net cash flow | 2000 | 3000 | 4000 | 5000 | 6000 |
If the minimum rate of return expected to be earned with the project is 14%, your NPV will be as follows:
NPV = 2000 / (1 + 0.14) 1 + 3000 / (1 + 0.14) 2 + 4000 / (1 + 0.14) 3 + 5000 / (1 + 0.14) 4 + 6000 / (1 + 0.14) 5 – 10,000
VAN = 12839.29 – 10000
VAN = 2839.29
Conclusion : the project has a NPV of 2839.29 with which we can affirm that it is profitable since it meets the expected rate of return of 14%, and also offers an additional profit of US $ 2839.29.
Internal rate of return (IRR)
The internal rate of return (IRR) is a tool that is usually used together with the NPV due to the relationship it has with it.
The IRR is the maximum discount rate that an investment project can have to be considered profitable.
To find the IRR, you must find the rate that allows the BNA to be the same as the investment (NPV equal to zero), so the formula to obtain it is the same as that of the NPV, except that instead of finding the NPV (the which is replaced by 0), is at a discount rate:
For example, if an investment project has an investment of US $ 10,000, and a projected cash flow of 5 years whose last line is as follows:
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| Net cash flow | 2000 | 3000 | 4000 | 5000 | 6000 |
Your IRR will be as follows:
0 = 2000 / (1 + i) 1 + 3000 / (1 + i) 2 + 4000 / (1 + i) 3 + 5000 / (1 + i) 4 + 6000 / (1 + i) 5 – 10,000
i = 23%
IRR = 23%
Conclusion : the project has an IRR of 23%.
Period of payback
The payback period is another financial tool commonly used in evaluating investment projects; but that as in the case of ROI, it also does not take into account the value of money over time.
The payback period measures the time it will take to pay back a project investment.
If the projected annual cash flows are the same, to find the payback period of the investment, the total investment must be divided by the projected annual cash flow.
For example, if an investment project has an investment of $ 10,000, and annual cash flows of $ 4,000, its payback period will be as follows:
Recovery period = 10,000 / 4,000
Recovery period = 2.5
The project will have a payback period of 2.5 years; but if the annual cash flows are variable, it is necessary to locate the investment within them.
For example, if an investment project has an investment of US $ 10,000, and the following annual cash flows:
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | |
| Net cash flow | 2000 | 3000 | 4000 | 5000 | 6000 |
Your payback period will be 4 years.
Breakeven
The break-even point refers to the level of sales where the income equals the costs; that is, at the level of sales where there is no profit or loss.
The equilibrium point formula is:
| Pe = CF / (PVU – CVU) |
Where:
- Eg : balance point.
- CF : fixed costs.
- PVU : unit sale price.
- CVU : unit variable cost.
Equivalent break-even sales means no profit or loss, break-even sales mean profit, and break-even sales mean losses.
For example, if the price of each product to be marketed is US $ 12, the variable cost of each product is US $ 8, and the fixed costs of the project amount to US $ 6,000, the break-even point will be as follows:
Bp = 6000 / (12 – 8)
Pe = 1500
Conclusion : the equilibrium point is 1,500 units (in monetary units it would be: 1,500 x 12 = US $ 18,000), with which we can affirm that from the sale of 1501 units, profits would only be starting to be generated, while lower sales at 1500 units it would mean losses.
Cost-benefit (B / C)
The cost-benefit ratio measures the relationship between the costs and benefits associated with an investment project.
The cost-benefit ratio formula is:
| B / C = VAI / VAC |
Where:
- B / C : cost-benefit ratio.
- VAI : present value of net income or net benefits.
- VAC : present value of investment costs.
If the B / C is greater than the unit, the project is profitable since the benefits will be greater than the investment costs; but if it is equal to or less than the unit, the project is not profitable since the benefits will be equal to or less than the investment costs.
For example, if the total expected benefits to be obtained for a 5-year period is US $ 20,000 (expecting a rate of return of 14%), and the total expected investment costs for the same period is US $ 10,000 (considering an interest rate of 12%), the cost-benefit ratio will be as follows:
B / C = (20000 / (1 + 0.14) 5 ) / (10000 / (1 + 0.12) 5 )
B / C = 10416.66 / 5681.81
B / C = 1.83
Conclusion : the cost-benefit ratio is 1.83, so we can affirm that the project is profitable, and that for every dollar that will be invested in the project, a profit of 0.83 dollars will be obtained.
Summary of results
The summary of the results obtained when evaluating the investment project of the examples is as follows:
The project has an investment of US $ 10,000, and a total projected cash flow of 5 years of US $ 20,000. According to the financial evaluation carried out, it is profitable and, therefore, viable.
The results obtained through the use of the financial tools used are the following:
- The project has a 5-year return on investment (ROI) of 200%.
- The net present value (NPV) of the project is US $ 2,839.29, assuming a discount rate of 14%.
- The internal rate of return (IRR) is 23%.
- The investment payback period is 4 years.
- The equilibrium point of the project is 1500 units, equivalent to US $ 18,000.
- The cost-benefit ratio (B / C) is 1.83 assuming a rate of return of 14%, and an interest rate of 12%.
Final notes
In this article we have shown you how to evaluate an investment project through the use of the main financial tools that exist for this purpose; However, you must bear in mind that to evaluate an investment project, not only figures, but also non-quantifiable factors must be taken into account .
For example, in the project we have been evaluating, in order to make the final decision of whether or not to make it effective, in addition to the results obtained, we could also take into account how closely it aligns with the mission of the company, how it would affect the reputation or image of the company, and what impact it would have on customer satisfaction or loyalty.
Please also note that in this article we have shown you how to evaluate an investment project such as, for example, a company to be created, and if what you are looking for is to know how to evaluate a company that is already operating, you can visit our Article: What is the financial analysis of a company? , where you will find the financial tools commonly used to analyze or evaluate a going concern.
Finally, if what you are looking for is knowing how to develop an investment project, you can visit our article: What is a business plan and how to make one? , where you will find the necessary steps to make a business plan and, therefore, to make an investment project.
