THE FINANCIAL STATEMENTS
KEY FINANCIAL INDICATORS
ACCOUNTING ISSUES
WHAT-IF ... SENSITIVITY MODELS
TIMING MATTERS
JUSTIFYING INVESTMENT
SCORECARDS AND VALUE MANAGEMENT

ACTIVITY: Investment Analysis Quiz

Research has shown that active recall, pushing yourself to recall new information rather than simply going over it again, has a big positive impact on learning and long-term memory. Also by trying to answer questions, you gain new insights and expose gaps in your knowledge.

So here is a short active recall activity. Click on the  heading to check your answer.

Present value is today’s value of a sum of money received in the future, taking into account time (when it is received) and the risk involved. It is calculated:

where i is the discount rate and n is the number of years from now.

Or more likely, you will use the Excel PV function.

So that we are able to:

  • evaluate whether a project returns value greater than the cost of the investment
  • compare projects, which may have differing levels of investment and cash flow pattersn

The payback period is the time that it takes to recoup the cost of the investment and is calculated by adding the cash flows, including the initial cash flow, until the sum of the cash flows is zero.

Firms often have a maximum allowable payback period against which all investments are compared. According to the payback period rule, a project is acceptable if its payback period is shorter than or equal to a specified number of periods known as the cut-off period.

The payback period suffers from two main weaknesses that limit its usefulness in evaluating investments:

  • it ignores the time value of money – money received in year five is regarded as equivalent to money received in year one
  • it ignores all cash flows beyond the payback period. A project may be rejected because it has a payback exceeding the cut-off period. Yet this project could have enormous positive cash flows beyond the payback period.

The advantage of the payback period is that it answers the very important question – how quickly do I get my money back. In some organizations this simple measure can be the most important because:

  • there is a constant stream of new projects requiring investment
  • the organization operates in an extremely dynamic market where the pace of technological development means that product life spans are very short

NPV is the value a project or investment generates, taking into account the initial investment, the timing of cash flows and risk. 

If NPV is positive, the project creates value.

Take the sum of the present value of all future cash flows and subtract the initial investment. As an equation:

But, like any sensible person, you will use the NPV Excel function:

The IRR is the discount rate that equates the present value of the cash flows and the cost of the investment – the break-even discount rate. So if there is an investment of $10,000, the sum of present values of future cash flows will be $10,000. 

IRR expresses the return a project generates as a percentage – and this simple output, allowing projects to be compared, means that it is a tool that managers like.

The IRR cannot be calculated directly. In this 4 year project, with an initial investment of $10,000, we must find the value of i in the equation below:

Or more likely, use the Excel IRR function.

 

There are 2 main issues:

  • implicit in IRR is the reinvestment of cash flows at the IRR. This can make projects with early cash flows seem much more attractive.
  • when cash flows vary between positive and negative, there can be multiple IRRs

We can ‘fix’ these flaws by using the MIRR – the Modified Internal Rate of Return. In Excel:

=MIRR(Values,Required Rate,Reinvestment Rate)

The Discount Rate is 10% and the cash flows for the project are:

Year 0 1 2 3 4
Cash Flow -45000 5000 6000 20000 35000

Try it yourself – you should get an NPV of: $3,435.90 and an IRR of 13%.