To understand how companies evaluate financial investments, let us take a look at the most commonly used 5 methods. Often, people misconstrue the word of finance with accounting. Both terms may seem interchangeable to a layperson since each of them technically involves number-crunching and data analysis. However, that is not the case.
Accounting is a broad subject with several branches that stem out of it. Finance and investing are one of those branches. The gist of accounting is more present-oriented and involves tabulating, bookkeeping, and maintaining financial accounts for any given fiscal year.
On the flip side, finance deals with more future-oriented decision-making. Accountants make a note of a company’s earnings for a given year. On the other hand, finance specialists suggest possible uses for the profits a company makes. These can include more financial investments to generate higher earnings in the future.
How to Evaluate Financial Investments?
Here are 5 methods to evaluate financial investments:
Method 1: Payback Period
The Payback Period is a fundamental and intuitive method to evaluate financial investments and potential opportunities. As the name suggests, this method weighs the number of years it takes for net cash flows from the investment to pay back its original capital amount.
To calculate the payback period, we must first calculate the cash inflows and the cash outflows that the proposed project will deliver yearly. After subtracting the inflows from the outflows, we get net cash flows per year.
When the net cash flows equal the initial investment amount, the number of years it takes is the payback period for the investment. Suppose one wishes to learn more about to evaluate financial investments.
In that case, it is recommended to complete an online master of accounting and brush up on their accounting and finance know-how. The online program is helpful for individuals who seek flexibility in their learning schedule while being able to work simultaneously.
Higher education can also help identify another way to understand the payback period, i.e., the number of years it needs for a project to pay back its original investment amount.
Let us assume that a company has to decide between two projects A and B.
- Project A has a payback of two years and six months while Project B has a payback of four years.
- Logic would dictate that Project A is less risky than Project B since it will soon recover its initial capital investment.
- Moreover, Project A will start generating profits much earlier than Project B.
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Method 2: Net Present Value (NPV)
It isn’t hard to understand that $100 today does not equal $100 five years in the future. While on paper, it may seem counter-intuitive since a 100-dollar bill will remain the same regardless of the fiscal year.
However, in the world of investing, money has time-value attached to it. Due to inflation, money loses value over time. A basket of goods that one can purchase today with a $100 bill will cost more in the future due to inflation.
Therefore, when it comes to evaluating projects, potential cash flows of the future are not equal to the same amount of cash flows today.
A net cash flow of $5000, realized two years later, will not be equal to $5000 today. In fact, after discounting at 10% per annum, $5000 realized after two years will be similar to $4130 today.
After discounting all net cash flows, the initial capital is subtracted to reach a net present value. If the NPV is positive, it implies the project can pay for itself even after factoring in the discount rate.
On the other hand, if the NPV is negative, it implies that the project is unrealistic because it will not be able to pay for itself after the discounting rate.
This method is crucial to evaluate financial investments since it caters to the “time-value” of money, which the Payback period does not.
Method 3: Accounting Rate of Return (ARR)
This method is also known as the return on investment method or return on capital employed method. It is a measure of a project’s profit compared to the investment and expressed as a percentage.
As logic would dictate, any project with a higher ARR or ROCE is a good investment because it denotes a higher return on the investment.
Suppose a company or individual has to choose between a few investment opportunities solely based on the profit rates offered.
In that case, ARR is one of the most effective methods of ranking investment opportunities. However, it is a quick method of evaluating an investment opportunity, but it does not fully depict the entire picture.
Two projects with entirely different capital requirements can give the same ARR merely because it is a ratio of profits and the capital invested to achieve those profits.
A project costing $1,000,000 with $100,000 in profits will give the same 10% ARR compared to a project costing $5000 with $500 in profit. Therefore, using this method as a stand-alone deciding factor can be misleading at times.
Method 4: Internal Rate of Return (IRR)
This method offers a percentage discount rate used during capital appraisals. The rate of return at which the future net cash flows equal the initial outlay is called the Internal Rate of Return.
Investors can also understand this as the rate of return for discounting future net cash flows to give a net present value of 0(Zero).
This rate is dependent upon the bank lending rate or the interest rate offered on the financing.
You can also consider the interest rate as an opportunity cost of funds that banks expect in return for providing funding for projects.
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Method 5: Profitability Index
Investors can calculate the profitability index of a project by dividing the present value of future net cash flows by the initial outlay.
What makes it different from the NPV method is that to calculate PI, the initial cost or the initial investment amount acts as the divisor in the PI method.
In contrast, it is subtracted from the present value of future net cash flows under the NPV method.
The profitability index is expressed in ratio form. If the PI is 1 or greater, it means that the project is profitable and will generate a positive NPV.
If the PI is less than 1, it means that the project is not beneficial and will cause a negative NPV.
Businesses and large companies typically use the five methods mentioned above to evaluate projects that can serve as suitable financial investments. Each method to evaluate financial investments has its own merits and demerits. Some are more comprehensive compared to others and factor in more variables.
However, it would be unreasonable to claim that a specific method is superior to another. When all methods are combined to perform a comprehensive analysis and decision, it can provide a more straightforward approach for ranking investment opportunities and zero-in on one.
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