Difficulties and ways to improve the accuracy of investment project evaluation

In the context of declining investment opportunities for businesses, an accurate analysis of investment efficiency is important. To reduce investment risks due to a large number of assumptions, a set of investment analysis indicators is used, each of which has its pros and cons. In this article, we will consider the problems and ways to improve the quality of investment project evaluation, as well as an algorithm for conducting investment analysis using an example.

General approach to evaluating the efficiency of investment projects

Investment decision-making is based on the assessment of the economic efficiency of investments. It depends on a combination of the following factors:

• the ability of an investment project to generate income, i.e. positive cash flows in the future during the entire period of the project;

• the amount of one-time and future expenses required to implement the project;

• the size and ratio of equity and borrowed sources of project financing;

• the cost of equity and borrowed capital;

• the time factor (the different cost of future cash flows is taken into account).

Complications may arise in the forecast analysis of these factors:

• investment expenses can be made either at one time or over a long period of time;

• in addition to capital expenditures, financial expenses may be required to replenish working capital for the implementation of the project;

• the calculation of the results of the implementation of the investment project is carried out within the forecast period, while the period of full functioning of the project in most cases exceeds the forecast period;

• a long period of the investment project leads to an increase in uncertainty in the assessment of all aspects of investments, i.e. to an increase in investment risk.

Therefore, to assess the effectiveness of the investment project, a system of indicators is used that in one way or another reflect the ratio of the results obtained and the costs incurred, depending on the interests of all participants in the investment project or a specific participant individually.

Instead of simply relying on intuition, the investor analyzes specific data to answer key questions:

How quickly will the invested money return?
What will be the total return on investment?
How risky is this investment?
How will this project affect the overall financial situation of the company?

Therefore, a comprehensive investment analysis includes the calculation and subsequent evaluation of a number of indicators that allow you to answer these questions and make an informed decision. Which indicators are used depends on the specifics of the project and the investor's goals, but in general, it allows you to get an objective picture and minimize risks.

Payback period of investments

The payback period of investments is the period of time from the start of the investment project until the moment when the investment income becomes equal to the initial investment costs incurred in the form of capital investments and investment expenses for replenishment of working capital. The economic meaning of the indicator is to determine the period during which the investor can return the invested capital.

The algorithm for calculating the payback period depends on the uniformity of the distribution of the projected investment income:

• if the income is distributed evenly over the years, the payback period is calculated by dividing the total investment costs by the amount of annual income due to them. When receiving a fractional number, it is rounded up to the nearest whole number.

• if the income is distributed unevenly, and in most cases this is the case, the payback period is calculated by directly calculating the number of years during which the investment will be covered by the cumulative net income, i.e. income calculated on an accrual basis.

The payback period indicator is very easy to calculate and understand. However, it has a number of shortcomings that must be taken into account when conducting investment analysis.

The key shortcoming of this indicator is that it does not take into account the difference in the cost of funds over time, i.e. it does not differentiate between investment projects with the same total amount of positive cash flows (income), but with different distribution over time.

Another important shortcoming of this indicator is that it does not take into account the factor of the influence of income received in periods after the payback period on the overall efficiency of investments.

In this regard, the payback period indicator provides only a primary (general) assessment of the investment project and cannot serve as a basis for making investment decisions.

Investment efficiency ratio

The investment efficiency ratio (ROI, Return on Investment) is perhaps one of the most popular and important indicators in the world of finance and business. In simple terms, it shows how profitable your investments were. It is like a litmus test that allows you to evaluate whether it was worth investing money in a particular project, stock, or even education.

The investment efficiency ratio shows the overall profitability of a project and is used for a preliminary assessment of the attractiveness of investments.

This indicator has two features:

• firstly, like the payback period of investments, it does not involve the calculation of discounted cash flows;

• secondly, the indicator of net positive flows is taken as accounting profit (minus fiscal payments), which is used on an average annual basis.

Important nuances:

Consider all costs: When calculating ROI, it is important to consider all costs associated with investments, including commissions, taxes and other expenses.
Compare with Alternatives: ROI makes sense to compare with other investment opportunities to understand how your investment is performing compared to other options.
Consider the Time Factor: ROI does not take into account the time it takes to generate a return. Therefore, when comparing investments with different payback periods, it is worth using other metrics, such as annualized yield.
Not a Perfect Metric: ROI is a useful metric, but it is not a perfect metric. It does not take into account risk, liquidity, and other important factors.

The investment performance ratio is a powerful tool for assessing the profitability of your investments. It helps you make informed decisions and optimize your investment strategy. However, it is important to remember that ROI is just one of many metrics to consider when making financial decisions. Use it in conjunction with other metrics and common sense to succeed in the world of investing.