Content

Introduction

I. General characteristics of investment efficiency methods

II.Method of discounted payback period

III. Method of net present value - NPV

IV. Method of internal rate of return - IRR

V. Comparison of NPV and IRR methods. Decision of minimum costs

VI. Evaluation of efficiency with the risk indices.

Conclusion
 Introduction

The choice of the theme “The concept of investment efficiency and methods

of its evaluation” is closely related to the fact that it is really difficult to imagine

any kind of economic activity without investments. According to the federal law

“On investment activity in the Russian Federation”, investments are cash assets,

securities and other property, including property interest and other interests that

have pecuniary valuation and that are invested in projects of business activity to

get profit or any other effective output.1

Effective use of investment resources is related to the problem of their

limited nature. Generally there are two ways of investment rationalization. If the

volume of investments for the certain project is taken then it is necessary to

maximize the investment productivity. And if the output that has to be reached

using investments is taken then it is necessary to analyze the ways of investment

costs minimization.

Other ways of evaluation include general effectiveness of the project and

participation effectiveness. Usually the first kind of evaluation covers social and

commercial lines and in both cases effectiveness is evaluated from the participant’s

point of view, person that carries out the project using his own means. This type of

evaluation is targeted on estimation of “project appeal” for prospective investors

and on search of new investors. The second type of evaluation is actually an

1
The Federal Law “On investment activity in Russian Federation” 15 July 1998
http://base.consultant.ru/nbu/cgi/online.cgi?
req=doc;base=NBU;n=70033;div=LAW;mb=NBU;ts=D10F1D2A5583AE05680BAE1E50B6D9
D2
evaluation of feasibility. All the methods are based on costs comparison, however

those vary by used approaches.

Nowadays a great deal of investment projects is carried out in different spheres and

some of them are successful and some are not. Therefore question is what makes

them successful? There is a lot of research about how the political situation can

affect the investment projects in various countries. But the more interesting and

deep subject is the calculation component in investment project evaluation.

Investment evaluation is considered one of the main skills that any project manager

has to acquire. It’s necessary to know not only whether the project is going to be

profitable but also to calculate the payback term and other long-run financial

perspectives. And because of the current crisis this issue has become of the vital

importance. More than ever the precise calculation is essential as investment

activity is becoming more and more risky. So in the synopsis we are going to raise

the main points of how to evaluate the investment efficiency of an investment

project.

I. General characteristics of investment efficiency methods

The international practice of investment evaluation is based on the

conception of time value of money. And investment evaluation is based on three

principles. First is to evaluate capital investment efficiency cash flows generated

during the project realization versus cash flows in initial investments. If the initial
amount of investments is recouped and required yield is reached then the project is

considered effective for investors. Secondly the invested capital and cash flows are

discounted. Third is that the discounting rates of investments and cash flows differ

and vary as the project requires.

The essence of all methods can be converted in the following scheme. If any

project is carried out the initial investments generate cash flows CF1, CF2, ... , CFn,,

and if the given cash flow is sufficient to recoup the initial sum of investments and

to reach the required return of invested capital the investments are considered

effective.

In international practice the most widespread indices of investment

efficiency are the following:2

• Discounted payback period (DPB)

• Net present value of investment project (NPV)

• Internal rate of return (IRR)

These methods of effectiveness evaluation are used both for evaluation of

independent projects to approve or reject the project and also for comparison of a

range of projects.

II. Method of discounted payback period

2
Savchuk V.P. “Investment project evaluation” chapter 7, 2000
http://www.cfin.ru/finanalysis/savchuk/7.shtml p.1
 As an abstract example two projects can be reviewed that are proposed to

have the same amount of investments with the prospective term of each project of

4 years. The cash flows of both projects are given per each year and the total

capital value is also given. First discounted incomes have to be calculated:

discounting here means separation of the part that is the investor’s income from

invested capital and the remaining part of it is necessary to recoup the initial

investments. Additionally non-recouped part of the initial investments is calculated

and eventually this non-recouped sum reduces. At the next stage the payback term

is determined by comparing discounted cash flow and non-recouped part of

investments. At the final stage the rate is calculated as the sum of payback years

and quotient of not-recouped sum and discounted cash flow of the next year. Using

the same calculations for the second project a conclusion is made which project is

more effective. The lower is the rate the shorter is the payback period and the more

effective a project is and vice versa.

III. Method of net present value – NPV

The method is based on the concept of Net Present Value. The initial

formula to calculate this index is the following:3

3
Savchuk V.P. “Investment project evaluation” chapter 7, 2000
http://www.cfin.ru/finanalysis/savchuk/7.shtml p.2
Here CFi is cash flows, and r is the value of capital involved in the project.

Every sum of money is determined as sum of inflows and outflows that is to

say “positive” and “negative”. According to the method, all the present outflows

(negative) are compared with all the inflows (positive). In particular, the difference

between the former and the later is the Net Present Value. This index defines the

decision.

Consequently the method consists of three stages. At the first stage the

present value of each cash flow is calculated. Then at the second stage all the

discounted values of flows’ elements are to be summed up and then the NPV is

calculated. And the third stage is a decision-making stage: if it is a separate project

and NPV is higher or equals zero the project is approved. For several projects, a

project is approved that has a higher NPV.

Below there is a description of effectiveness evaluation method in case of

inflation influence. Inflation influence analysis can be carried out in two different

ways. When the rate of inflation differs for all types of resources and when the rate

of inflation for different resources equals. For the real situation the first approach is

preferred, especially if the analysis is carried out in the country with unstable

economy. According to the NPV method all the components of incomes and

expenditures are adjusted according to the prospective rate of inflation. However,

it is hardly feasible to calculate the rate of inflation for different types of resources.

According to the second method, inflation influences intermediate calculations but

does not influence the final result and consequently does not influence the decision
on project. In one Russian publication of Savchuk V. P. “Evaluation of investment

project efficiency” an example is given of NPV calculation with and without the

inflation. The results are equal, as the inflows and return rate were adjusted. The

author assumes that is the reason why most of Western countries calculate

investment efficiency without taking inflation into account.

IV. Method of internal rate of return – IRR

Internal rate of return is an interest rate when Net Present Value equals zero.

Economically, Internal rate of return means the rate of investment return when the

firm benefits equally from investing capital to any financial instruments at certain

interest or from investing to real project and generating cash flow, every

component of which will be invested at the same interest.

Mathematically, the Internal rate of interest can be calculated from the

following equation.4

4
Savchuk V.P. “Investment project evaluation” chapter 7, 2000
http://www.cfin.ru/finanalysis/savchuk/7.shtml p.5
Here CFt is the incoming cash inflow during t-period, IC is the volume of

investments.

IRR can be calculated from this equation. Further a decision is to be made: if the

IRR exceeds or equals capital value then the project is approved and vice versa.

V. Comparison of NPV and IRR methods. Decision of minimum costs

Very often methods of investment effectiveness evaluation using NPV and

IRR can contradict each other. But it is very important to point out that this

situation can exist only while comparing alternative projects. For investment

efficiency evaluation of a separate project, positive NPV always will meet the

situation when IRR exceeds capital value.

It is necessary to mark out separately a method of decision making

according to criteria of the minimum value as there are projects for which money

methods are hardly applicable. For instance, the investor can face such a situation

when an enterprise is going to modify manufacturing or transport equipment that is

involved in different production stages and when it is impossible to calculate the

final cash flow. In such cases the cost of operating is used as the main criteria for

making a decision. The method consists in all the costs calculation. Then the

process of discounting goes and the minimum value of discounted costs is chosen.
 VI. Evaluation of efficiency with the risk indices

In Western publications investment efficiency is usually seen as a combination of

financial and non-financial efficiency indices. Thus indices of risk and return are

used to evaluate efficiency. The risk-adjusted measures capture the efficiency with

which risk is “converted into” return. One of the most widespread efficiency

measures is the information ratio (IR). The information ratio is a risk-adjusted

measure that considers risk and return relative to the benchmark. This can be

calculated ex post, using achieved active returns and achieved active risk values, or

ex ante, using expected active returns and predicted active risk measures.

A ctive_ retu rn 5
Information ratio = A ctive_ risk

The information ratio can be calculated gross or net of costs. This can be expressed

in the following relationship, where costs are both the investment management fees

and the monitoring costs:

Active_ return− Costs6

Net information ratio (Net IR) = Active_ risk

5
“The concept of investment efficiency and its application to investment management structures” Hodgson
T.M.; Breban S.J.; Ford C.L.; Streatfield M.P.; Urwin R.C British Actuarial Journal, Volume 6, Number 3, 2000
p.474 http://docstore.ingenta.com/cgi-
bin/ds_deliver/1/u/d/ISIS/54820601.1/fia/baj/2000/00000006/00000003/06020451/F046E50F04F9F08E126531568
9F97882EC3C5A1706.pdf?link=http://www.ingentaconnect.com/error/delivery&format=pdf

6
“The concept of investment efficiency and its application to investment management structures” Hodgson
T.M.; Breban S.J.; Ford C.L.; Streatfield M.P.; Urwin R.C British Actuarial Journal, Volume 6, Number 3, 2000
p.474 http://docstore.ingenta.com/cgi-
bin/ds_deliver/1/u/d/ISIS/54820601.1/fia/baj/2000/00000006/00000003/06020451/F046E50F04F9F08E126531568
9F97882EC3C5A1706.pdf?link=http://www.ingentaconnect.com/error/delivery&format=pdf
Both indices are useful in evaluation of investment manager’s activity. The

information ratio is a useful statistic in ranking the skill of investment managers. A

higher information ratio indicates that the manager can add more value per unit of

risk. Thus the task of investment consultants is to find qualified investment

managers and project with a high level of IR.

Conclusion

Nowadays there are a lot of approaches of investment efficiency evaluation.

This paper examines three monetary approaches: method of discounted payback

period (DPB), method of Net Present Value of the investment project (NPV),

method of internal rate of return (IRR). And non-monetary approaches: decision

making according to criteria of minimum value and evaluation of information ratio

with risk-adjusted component. Choosing the approach to evaluate the investment

project it is necessary to clarify the targets. Thus the calculation method and the

efficiency of decision heavily depend on project quantity and its peculiarities.

Furthermore, for certain method, assumptions and their accordance with the real

practice are significant. The first assumption is that all the cash flows are dated

from the end of the period in spite of the fact that they can emerge during the

period. The second assumption is that the cash flows generated by investments are

immediately invested in another project to provide additional income. At the same

time it is considered that the return rates of other projects are not lower than the

rate of the current project. And despite the fact that these assumptions do not

totally correlate with the real circumstances they do not result in serious errors of

investment efficiency evaluation as most of projects are long-run projects.

 Bibliography

1. “The concept of investment efficiency and its application to investment

management structures” Hodgson T.M.; Breban S.J.; Ford C.L.; Streatfield

M.P.; Urwin R.C British Actuarial Journal, Volume 6, Number 3, 2000 , pp.

451-545

http://www.ingentaconnect.com/content/fia/baj/2000/00000006/00000003/0

6020451

2. Savchuk V.P. “Investment project evaluation” chapter 7, 2000

http://www.cfin.ru/finanalysis/savchuk/7.shtml

3. The Federal Law “About investment activity in Russian Federation” 15 July

1998 http://base.consultant.ru/nbu/cgi/online.cgi?

req=doc;base=NBU;n=70033;div=LAW;mb=NBU;ts=D10F1D2A5583AE0

5680BAE1E50B6D9D2