Comparing return on investment is a tool for decision making
The investments have an impact on the company’s profitability, liquidity and assets. This is why it is necessary to evaluate and compare investments, which is aided by return on investment indicators.
Return on investment indicators are often used by businesses when calculating the efficiency of the use of available assets. For businesses, for example, ROI is most commonly used for that purpose.
In order to be able to compare your investments and be able to properly evaluate efficiency, you need to know why you are implementing it. Thus, investments can be:
- start-up investments: these are called greenfield investments because you create and operate something completely new.
- replacement investment: replaces worn-out goods
- expansion investment: aims to expand your existing capacity (same quality, you can only produce more)
- modernization investment: represents a qualitative change compared to the past.
When assessing the economics of the investment, we observe the following:
- Starting cash flow: the cost of the investment
- Cash flows from operating activities: these can be revenues and they can be expenses
- Final cash flow: cash flows at the end of the life of the investment or at the end of the project This can be revenue (eg sale of a used machine) but it can also be an expense (tax implications, restoration costs)
When planning the investment, these items are taken into account according to their due date. Here again, it is true that cash flows generated at different times cannot be added together numerically. We need to discount them (this shows their value expressed in the present moment) so that we can add up future revenues and expenses and thus compare different profitability.
Indications for return on investment
PV: Indicates the present value. Discounted value of future cash flows. That’s what it’s worth today if you got it now.
C: capital, this is the amount you pay out or receive as income.
n: time frame, that’s how long your money works
r: interest rate, discount rate
The discount rate and interest rate used here can be according to the company’s decision:
- return on alternative investment: then you get the answer to the question whether you are doing better with the investment or realization of the investment in the period in question
- loan interest: whether it extracts its cost of capital
- average inflation rate: you get an answer to whether you keep your money in purchasing power by making the investment
- other return expected by the business: this can be all of the above (eg generate interest on the loan and do better than if you had invested elsewhere your capital)
The present value calculation has already been discussed in the article Time Value of Money, so now we will only review the return on investment indicators, we will only touch on the present value calculation.
An example of the use of return on investment indicators.
I will use the numbers in this example to illustrate how the indicators work. Pardon me, I’m going to use numbers that are very out of touch with reality. My goal is not to create a complete business plan, but to make it easy to count on them, making it easier for you to understand how the metrics work.
Our example will be a start-up investment, you have decided that you will be dealing with chocolate packaging. You would buy a chocolate packing machine for 100,000 forints, which is planned to operate for 3 years and then be completely scrapped. During these 3 years, it will generate 50,000 forints a year for you. Since you could find another place for this 100,000 forints, the expected return is 10%.
Same with numbers:
C0: 100.000 ,- Ft
n: 3 years
The question is whether to jump into the chocolate packaging or look for another place for your money.
Return on investment indicators
Net present value (NPV)
NPV = -C0 + ∑ Ct / (1+r)n
Net present value is the sum of the discounted values of all expenses and total revenue incurred during the investment.
We could also write like this:
NPV = PV(Hozamok) – PV(Ráfordítások)
This gives us the present value of the cash flows expected to be generated during the investment. When calculating the net present value, pay attention to the direction of cash flows: revenue is marked with a positive sign and expenditure with a negative sign.
Interpretation of net present value
If this number is
- positive, then that particular investment is expected to yield above our expectations.
- is 0, then the amount coming from it will be in line with our expectations.
- negative, then our expectations are not met, i.e. it is not worth it to implement this project.
Example of using net present value
NPV = -100.000 + 50.000 / (1+0,1)1 + 50.000 / (1+0,1)2 + 50.000 / (1+0,1)3
Here, the starting cash flow is displayed with a negative sign. Since you are paying this at the present moment, its present value will be the same as the value you paid. For other cash flows, the exponent depends on in how many years you get it.
NPV = 24.343,- Ft
By using the net present value, you get that the machine you are looking at is performing beyond your expectations.
An alternative example of calculating net present value
Suppose that the above example is supplemented in that it is planned to renovate the packaging machine in the 2nd year in the amount of 45,000 forints, but in the end the machine will not be completely scrapped, but you can sell it and get 10,000 forints for it.
NPV = -100.000 + 50.000 / (1+0,1)1 + 50.000 / (1+0,1)2 – 45.000 / (1+0,1)2 + 50.000 / (1+0,1)3 + 10.000 / (1+0,1)3
In this case, the planned cost of the 2nd year is shown with a negative sign, but its present value is not HUF 45,000. In order to calculate the net present value, you need to discount. The same is true of the proceeds from the sale of the machine at the end.
NPV = -5.334,- Ft
So by then you are better off choosing another solution. With this, you were able to filter out the investment that is not suitable for you at all in one step.
Profitability index (PI)
An indicator similar to the net present value, you only get it as a fraction here. You compare the total income of the investment to the expenses.
If the investment is made with a single initial expenditure, the profitability index compares profitability to the initial cash flow:
PI =( ∑ Ct / (1+r)n ) / C0
In a phased implementation, not the initial expenditures are authoritative, but the present value of revenues is then compared to the discounted value of subsequent expenditures.
PI = PV (Hozamok) / PV (Ráfordítások)
Interpretation of the profitability index
If the profitability index is 1, it means the same as if the net present value is 0. That is, you get the return you expect, but you can’t expect more.
If the profitability index shows a value higher than 1, then the investment will bring your expectations above your expectations, and in the case of a value below 1, it is not worthwhile to implement the given idea.
Example of using the profitability index
By entering the numbers of the chocolate machine example above, you can get that
PI = (50.000 / (1+0,1)1 + 50.000 / (1+0,1)2 + 50.000 / (1+0,1)3 ) / 100.000
Calculated you get that
PI = 1,243
An alternative example of using the profitability index
As with net present value, assume the planned extra expense here as well as the proceeds from a sale at the end.
PI = (50.000 / (1+0,1)1 + 50.000 / (1+0,1)2 + 50.000 / (1+0,1)3 + 10.000 / (1+0,1)3) / (100.000 + 45.000 / (1+0,1)2 )
Given that here the revenues are in the numerator of the fraction and the expenditures are in the denominator of the fraction, so the sign is positive everywhere.
PI = 0,9611
As the profitability index here no longer reaches the minimum expected value of 1, it is no longer worth implementing under these conditions.
Internal rate of return (IRR)
Own (internal) return on investment. It shows how much profit we will make with implementation over its lifetime. Then the discounted value of the returns is equal to the total present value of the expenses.
PV (Yields) = PV (Expenses)
0 = -C0 + ∑Ct / (1+r)t
When calculating the internal rate of return, pay attention to the sign of the cash flows. Just because there is a mathematical solution, it is not yet certain that there will be an economic solution.
Interpretation of the internal rate of return
When calculating the internal rate of return, we get at which yield level the net present value will be 0
If the interest rate given by the internal rate of return is the same as the market rate, you will achieve the same as if you had invested elsewhere.
If it is higher than this, you can gain more on your investment than with the available investments, while if it is lower than the expected interest rate, you will achieve more with your money elsewhere.
This can be important where the question is whether a particular investment will generate its own costs. Then the expected return e.g. the interest on the loan, if the internal rate of return is lower, you will not be able to pay the bank.
Example of using the internal rate of return
In the case of the internal rate of return, we can solve it by an approximation method or by using the Excel IRR function (it also uses an approximation method based on its description).
IRR = 23,38%
The total return on investment is 23.38%. This means that at this yield level, 0 is the net present value. In contrast, with the 10% return expectation you expect, you can see that you are achieving more with this path.
An alternative example of using the internal rate of return
Here we also take into account the planned renovation and sale of the machine.
IRR = 7 %
The total return on investment is 7%. Although this is more than zero, it is nowhere near as much as you would expect from him, i.e. as much as you get elsewhere for your money.
Investment amount / net annual income
The payback period shows how many years the investment will pay off from the net return on the investment. For some investments, a payback period of more than 10 years is perfectly acceptable, which is why there is no good or bad solution here. The only question is whether you can sustain and finance the period until the cash flow turns positive.
Profitability (profit margin)
Net annual income / Investment amount
It shows how much annual income changes a given amount of start-up capital creates. Of course, the goal here is to make as much change as possible with a given amount of capital.
Interpretation of return on investment indicators
Indicators are just numbers in themselves, they should always be placed in the right context. It cannot be said that from the positive return outlook of an investment, let us implement it immediately.
Indicators help you make decisions, but they don’t decide for us. Clear situations (e.g., unprofitable investment) are filtered out, but it is always up to the business management to decide what the priority is.
There are investments that pay off faster, while others bring in far much more money over their life expectancy.
If you decide to make an expansion investment, when interpreting the indicators, be sure to subtract the existing value from them to get the actual growth. Based on your decision, it may be a better idea to break down the old solution and build a better quality one instead. In this case, the return indicators can be distorted if you do not take into account the possible costs of dismantling as well.
- Which indicator do you use when planning your own investments?
- What do you usually focus on for each indicator?
- What do you consider to be the greatest difficulty in applying indicators?
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