Return on investment is one of the basic economic indicators, which investors and entrepreneurs rely on to evaluate the performance of a business, financial instrument or other asset. Since investment means long-term investments, it is important for a potential business angel to know how quickly his investments will pay off and what income they will bring in the future.
Why is ROI calculated?
The return on investment ratio, or ROI (Return On Investment), is constantly monitored by entrepreneurs and investors with one simple goal: to determine how effectively an asset is generating income.
ROI - Return on investment ratio
ROI is a fairly versatile way to find out:
- is it worth investing in a certain startup;
- how justified is the modernization or expansion of the business;
- how effective is an advertising campaign that is carried out offline or online;
- whether to buy shares of a certain campaign;
- whether the acquisition of a share in a mutual fund is justified, and so on.
Using indicators that are freely available and available for analysis to everyone, you can easily calculate the ROI coefficient and draw the appropriate conclusion. If ROI is less than 100%, then this financial asset is inefficient. If more than 100, then it is effective.
Usually, the following data is sufficient for calculations:
- the cost of the product (includes not only the cost of production, but also the remuneration of employees, the cost of delivery to the warehouse and to the point of sale, insurance, and so on);
- income (that is, profit received directly from the sale of one unit of a product or service);
- investment amount (the total amount of all investments, for example, advertising or presentation costs);
- the price of an asset at the time of purchase and at the time of sale (this indicator is of greater importance not for businessmen, but for investors who use fluctuations in the price of an asset - a share, a currency, a share in a business, and so on - to resell it and make a profit).
For business people, when analyzing products, calculating ROI has a special meaning. With a wide range of goods or services, analysts analyze each group of goods according to various indicators. As a result, to put it simply, it turns out what sells worse and what sells better. Sometimes business owners make interesting discoveries for themselves. So, it may turn out that low-margin products bring more income than high-margin products, although according to reports in absolute numbers, everything looks different.
Depending on the results obtained, you can develop an action strategy: strengthen those positions where the highest ROI is to get even more profit, or “pull up” weak positions in order to “pull up” the business as a whole.
There are several formulas for calculating ROI. The simplest one used by investors and marketers looks like this:
ROI = (revenue - cost) / investment amount * 100%.
The same formula can be expressed in a slightly different way if you need to value financial assets whose cost changes over time (for example, shares):
ROI = (return on investment - amount of investment) / amount of investment * 100%.
These formulas are designed for the short term, that is, they are designed to calculate the efficiency for a given time period. But it often happens that for a more accurate value of the ROI coefficient, you need to add a period. Then these formulas are transformed into the following form:
ROI \u003d (Investment amount at the end of the period + Income for the selected period - Investment amount) / Investment amount * 100%.
For some financial assets the following formula is more suitable:
ROI = (Profit + (Sale Price - Purchase Price)) / Purchase Price * 100%.
Thus, these formulas are flexible enough to be able to substitute a variety of values and use them in different situations for various financial instruments.
One of simple examples calculating the ROI coefficient when you need to compare the effectiveness of selling different products in one outlet.
For example (goods and prices are conditional).
The following formula was used to calculate ROI: ROI = (profit - cost) * number of purchases / expenses * 100%.
The analysis of the received data prepares many interesting discoveries for the owner of the outlet. So, the sale of bicycles to him is clearly unprofitable, scooters are profitable, and skates do not bring any expense or income.
In order to correct the "weak" position, he needs to either reduce costs (for example, find a cheaper supplier) or increase the selling price. As for the skates, then you need to think about it. If it is summer, the number of small sales may be justified by the fact that it is “out of season”. In the autumn it will be necessary to carry out similar monitoring again.
For stocks, the calculation of the ROI coefficient will be as follows.
We use the formula ROI = (Dividends + (Sell Price - Purchase Price)) / Purchase Price * 100%.
From the analysis of the above table, the shareholder can draw several conclusions. Even though the price of a share may have risen, not receiving dividends on it results in a low ROI, despite the fact that the transaction as a whole looks profitable. Conversely, receiving dividends resulted in a large ROI despite the fact that the value of one share decreased.
This example perfectly illustrates the basic principle of investing in stocks: their longevity.
Advantages and disadvantages of ROI
The ROI helps investors and potential business owners evaluate how effective a project is. The higher the ROI, the more attractive the project looks in the eyes of other financial market participants.
In addition, the profitability index has several more pronounced advantages:
- takes into account the time factor, that is, the change in the value of assets over time, the profit received during the measurement;
- considers the sum of all effects from investments, and not just short-term profits;
- allows you to adequately evaluate projects with different scales of production or sale at the same level, for example, a large factory and a small workshop, a boutique selling fashion handbags and a clothing hypermarket;
- allows you to take into account in your formula the interest that you have to pay for the use of borrowed funds;
- flexible formula allows you to use various indicators and modify it as needed.
However, this ratio is not without drawbacks:
- by itself, ROI does not give any assessment of the profitability of a business or a financial instrument (which is clearly seen in the example of stocks);
- the ROI coefficient does not take into account the effect of money depreciation;
- it is impossible to predict the percentage of inflation, so long-term forecasts are rather vague (but you can rely on the average annual percentage of inflation).
The ROI value, together with other indicators, allows you to reasonably assess how profitable it will be financial instrument and whether it is worth risking your money and time to invest in another project.
Investments are investments of a certain sum of money into a project in order to implement it and convert it into a permanent profit. The main goal of investment activity is the constant receipt of income from invested funds, which must exceed the initial capital at times. Each investor is aware that the return on investment is the key to the successful conduct of business, as well as an excellent indicator of the effectiveness of the invested project. If an investor, having a limited amount of capital, has several proposals for investing in projects, he will choose the best option, which stands out due to such an indicator as the return on investment index.
The first step is to understand how to calculate economic benefits in absolute and relative terms. To do this, you should have a good understanding of the question of which project, when minimum investment and costs will bring big profit.
Let's study the analytical index of return on investment, learn how to apply the formula to calculate the return on investment, and also theoretically analyze necessary formulas to assess profitability.
ROI Formula
The profitability of an investment project is defined as an indicator by which the investor understands how effective his investment is. It can be used not only in investment activity, but also when assessing the level of income of an enterprise or for comparing the profitability of different products from entrepreneurial activity. The return on investment index is considered to be universal, which means it is used to compare the productivity of different scales of production or projects. Mathematically speaking, profitability invested capital defined as the ratio net profit to the original capital.
The efficiency of the calculation is achieved using a formula that acts as a method of return on investment.
Did you understand the coefficients? The profitability calculated in this way will be justified. To do this, the investor needs to know the initial cost of all products, the income of the enterprise, as well as investments in marketing. When getting a value > zero, the investment progressivity index will be optimal.
It is necessary to calculate the return on invested capital, because:
- the distribution of flows is taken into account Money in time;
- the amount received during the entire investment project is specified;
- it analyzes which of the proposed projects may be more profitable for the investor.
Methods for calculating the return on investment are reduced to calculating the profitability of the project and to assessing the increase in capital. To highlight the golden mean of profit, a return on investment ratio is required, which can be achieved through the ratio of net profit to the amount of equity capital of the organization.
It is important to understand that in order to determine the profitability of an investment project, it is not enough to know the quality of investments. The ROI indicator only indicates the effectiveness of the investment, reflecting the return on the money spent. In order to calculate the ratio of capital and income received, it is necessary to familiarize yourself with such a concept as the index of return on investment (pi).
Calculation of investment return index formula
Profitability Index (pi) is a coefficient obtained by calculating the relative return on investment. Calculation formula:
Analyzing ratios net worth investment in money equivalent and the total amount of investment invested in the project, we get an indicator of the profitability of the investment.
The value of pi cannot be displayed without the Net Present Value coefficient. This standard can be reversed through a specific expression:
Let's try to understand the concepts of all these values:
- n - the period of time, calculated in years, for which the investment project exists;
- r - the rate that must be used when recalculating the planned income into a single volume with the already existing value;
- cf - funds received each year for the maintenance, development and maintenance of the investment project.
How to correctly evaluate the return on invested capital?
The level of return on investment is conventionally denoted as pi. Whether an investment project is expedient or not will be decided only after the profitability index indicator is in the desired range:
- profitability index > 1 (the best indicator for an investment project, as it will bring more profit);
- indicator \u003d 1 (it is worth thinking about its profitability, some indicators of the progressivity of invested funds may turn out to be insignificant);
- profitability index< 1 (инвестиция не оправдывает ожиданий инвестора, так как проект не дальновиден).
Despite the simplicity of the indicators and the computability of the formula, the definition of the discount rate becomes incomprehensible. Why? This rate is influenced by many factors that are almost impossible to predict. The foreign policy, economic situation in the country can give rise to a change in the discount rate. Uncertainty may increase if the life of the project is long.
How to correctly estimate the discount rate?
First of all, it should be noted that the discount is an indicator that displays the amount of cash in the flow relative to future income. In order to correctly estimate these returns, the investor needs to keep in mind forecasts of revenue, expenses, as well as the structure of capital and investments. From the point of view of economics, the discount rate is an indicator to which it is necessary to strive for when investing capital. These figures can help in making many key decisions, as well as deciding between projects.
The ROI formula requires a discount factor. To calculate it, it is important to understand the minimum income threshold, the dynamics of inflation, as well as the rate that indicates the risks of what the investor invests in. Before you learn how to calculate the index of profitability of investments, you should take into account the role of the rate. So, the discount rate will help you understand the exact profitability of the project, as well as comparing the performance of the project with a minimum income when investing in a similar business.
There are several ways to estimate the discount rate. In the case of lending, the lower threshold of the discount rate will be the interest on the loan, since otherwise the investor will not be so interested in direct participation in the project. When financing the project with own funds, the discount rate will be equivalent to the indicator of the initial capital.
Thus, the calculation of the return on investment is made according to several indicators. Wherein:
- net present value must stop at a mark greater than 0;
- profitability invested investments shows a coefficient greater than 1;
- the internal rate of return on investment is calculated according to the equation depending on the specific situation (how the investor received funds for the project).
Profitability capital investments recalculated in several cases: at the time of selection desired project or when comparative analysis several projects, as well as directly at the time of the project and after its completion.
It is quite difficult to evaluate such a process as return on investment, although there are indicators that require the least analytical costs. Now let's look at the concept of "payback period" (PBP). Theoretically, the payback period refers to the period of time required to ensure the receipt of funds to make up for investment costs. The unit of measurement for this indicator is a year. The rate of this time is also very important at the stage of evaluating such a process as return on invested capital.
Mainly, the predicted payback period will come in handy for the investor in conditions of instability. economic system in the country or when choosing a business with advanced technologies. If you believe the practice, in Russia, with the current domestic economy, the payback period for projects is close to 3 years. In more developed countries this figure can vary from 7 years.
Calculation of the discount return on investment index (iddi formula)
The discounted investment yield index is calculated so that the investor can analytically represent all investments during the implementation of investment production, and not just the costs spent at a time for the first time. The discounted index formula is:
The numerator of the formula contains the familiar NPV indicator, and the denominator contains the data ic, i.e. the capital of the funds that was originally spent.
Having calculated the discount rate, it is possible to directly evaluate the effectiveness of the project that the investor chooses for his own capital investments. The estimate is made according to the familiar algorithm for extracting the coefficient pi. The DPI indicator is optimal if it turns out to be more than 1. In this case, the forecasts about the invested project will be justified, it can be considered for further investment. If DPI is equal to 1, the conclusion is simple: the costs that were spent will be at the same level as the profit that the investor will receive from the project.
In other words, the investment project will cost zero, which does not correspond to the main goal of investing. Production is unequivocally removed from consideration if the discount indicator is less than 1, such a project will incur losses. There are cases when DPI(1) is greater than the DPI(2) norm. This means that the investor needs to choose the project option with the first coefficient, since it is more attractive from the point of view of investment activity.
Social investment indices
The concept of "social investment" as a clear definition of investment activity does not exist. Rather, it is an established concept that has a specific purpose - to attract a positive effect in the eyes of the public. Investments in the development of low-income and underdeveloped regions, as well as investments in the corporation's own employees (training courses) can be examples of such projects. Thus, social investors (this is what the investors of their own investments in social projects) direct funds to the development of solving the problems of society as a whole or separately of some organizations.
The effectiveness of such projects, as a rule, cannot be accurately determined. It is necessary to determine social investment through the calculation of the results from the social effect. How can you calculate which social investment project will be the most favorable?
First of all, screening for a negative or negative indicator of a particular object of investment activity is important. Such a check excludes unnecessary projects.
Secondly, screening for a positive or positive indicator is equally important. The investment project development strategy should include such social sectors that could provide maximum efficiency and progressiveness. It is important to combine these checks in order to correctly assess the return on investment.
In the case of assessing the profitability of social investments, it is important to take into account several factors, resulting in a two-factor model. in a simple way profitability forecasting will be considered a social bond business plan, since the progressiveness is determined initially. The numerical indicator is set, it remains to be implemented so that the contributions show the expected result.
The investor needs to invest money, set strictly achievable goals, analyze their achievement. Such an assessment can be made in the case of the pay-for-performance model. By investing in social projects, customers and investors are unlikely to receive a return equivalent to market investments. Most likely, social investment activity should pursue somewhat different goals, for example, raising one's status in the eyes of the public, popularity or charity.
Positive and negative aspects of the profitability index
- opportunity to analyze comparative characteristic various projects that could qualify for development through investment;
- there is a very high probability of predicting risks and avoiding them with less loss for the business.
In contrast, there are several disadvantages of calculating the efficiency of investment production:
- calculation of forecasts for future cash flows;
- the cost of resources and time to assess the discount rate for different projects;
- the expenditure of resources and time to assess the impact of factors on future cash flows, which ultimately seem completely unpredictable.
(Return on investment, ROI) is perhaps one of the most important ratios in financial analysis enterprises. It shows the efficiency (profitability) of the enterprise from its activities. It is calculated either in relative terms or as a percentage. The ratio is used by investors to evaluate and compare different investment projects regarding their effectiveness. The higher the value of the coefficient, the higher the profitability of the enterprise. But the higher the profitability, the lower the liquidity of the enterprise. With low liquidity comes the risk of bankruptcy.
This ratio shows how much profit the investment invested in the enterprise brings. Here is the formula for calculating the return on investment ratio.
The formula for calculating the profitability ratio of investments by balance sheet
ROI ratio= Profit / Amount invested in the enterprise
ROI ratio= Net income / (Share capital + Long-term capital)
ROI ratio= line 190 Form No. 2 / 0.5* [(line 490 + line 590) at the beginning of the period + (line 490 + line 590) at the end of the year]
The greater the ROI, the more profitable and efficient the company works and uses investment capital. This ratio is useful for stakeholders, investors, creditors, as well as business owners.
its scope and calculation method
In addition to the indicator of net present value for evaluating the effectiveness design solution at medium-sized enterprises, the indicator of return on investment is widely used. We can say that both indicators are of the same nature and reflect the same essence, but only from a different angle.
Economic meaning of the indicator return on investment lies in the fact that it reflects the share of net present income per unit of investment investments discounted to the beginning of the life cycle of the project. This ROI is calculated using the formula
In this formula, all indicators and parameters have the same economic meaning as in formulas 8.6 and 8.7.
If in this formula substitute the initial information of the example considered in the previous paragraph, then with the discount rate q n = 0.06 return on investment will be P = 0.0804. This result is obtained by dividing the value 5131.71 by the value 4749.99. Then, one is subtracted from the quotient of the indicated values and the desired return on investment is obtained - 0.0804.
What characterizes the result, what is its economic meaning? It means that by applying this option, the investor will fully return his investment for life cycle of the project and, in addition, will receive a net present value of approximately 8% of the advance payments.
The noted result of the calculation is also shown in the graph (Fig. 8.1). If we move along the curve to the left and up to the origin, then the return on investment in this case will be P = 0.8234. This means that without taking into account the time factor and lost profits, insurance and the minimum established profitability of the project, the return on investment will be approximately 82.3%, i.e. spent 100 den on the project. units, the investor after its completion will receive a total income of 182.3 den. units.
8.4. Payback period indicators
and new business
One of the most important indicators of investment efficiency for small businesses is the payback period, because it is very important for an entrepreneur who does not have a lot of money capital to return the money contributed to the business as soon as possible. Therefore, very often, when deciding on investment, an entrepreneur focuses primarily on assessing the return on investment.
The economic essence of the payback period indicator is as follows. Suppose an entrepreneur invests 100 den in the project. units. As a result of the operation of the project being implemented, he annually receives 25 den. units. Consequently, the entrepreneur will return his advanced financial resources in four years. Such information is of great interest to him, showing whether it is worth investing money in this business and how quickly they will return to him.
Business practice has developed several indicators of the payback period of investments, and each of them has its own purpose and reflects some aspect of the project's efficiency.
Payback period of investments. The essence of the calculation of this indicator can be illustrated in the graph (Fig. 8.2).
Fig.8.2. Determination of the payback period of investments
The abscissa shows the current time in the accepted time intervals (in years, half-years, quarters, months, etc.). On the y-axis are plotted investment investments cumulatively in the accepted currency and income received in the same currency and also cumulatively. There comes a point when both curves intersect. The point of their intersection will determine the payback period of investments. In the presented figure, this indicator is equal to 6.5 time intervals. It is obtained based on the following data accepted by the condition:
In addition, it is known that the operation of the project begins from the second time interval.
As can be seen from the figure, the profitable component of the project crosses its investment component on the chart exactly after 6.5 time intervals. This means that through income from the operation of the project, the entrepreneur will return his investment within the specified period.
(8.9)
where K i- investments in the project in i ohm time interval;
D i- the income of the entrepreneur from the operation of the project in i-th time interval;
t - the number of time intervals for the operation of the project, for which the total investment will be equal to the amount of income from the operation of the new business (this will be the desired payback period of investments).
In the considered example, the total investments, as follows from the schedule, will exactly equal the amount of income from the operation of the project after 6.5 intervals, which fully corresponds to the condition of formula 8.9.
Payback period of the current project (object). The payback period of the object differs from the indicator of the payback period of investments. This difference is due to the fact that the operation of the project begins a little later than investment investments begin. Consequently, the payback period of the object (i.e., a functioning project) will be less than the payback period of investments.
The value of the indicator of the payback period of the operating object can be determined by the formula
t o= t ― ∆ t ,(8.10)
where t o is the payback period of the operating object in selected time intervals;
t - payback period of investments in the project (in the same time intervals);
∆t - time from the start of investment to the start of operation of the project (in the same time intervals).
If we use the condition of the example presented in the graph, then we can state that the payback period of the operating object will be equal to 4.5 time intervals according to formula 8.10. This value is the difference between the payback period of investments (6.5) and the shift in the start of operation of the facility (2.0).
The considered indicator characterizes the reserve of time that each entrepreneur has to reduce the payback period of investments. It is only enough for him to find such opportunities, the implementation of which will allow the project to start operating faster.
Income growth rate. The essence of the coefficient of increase in income (Fig. 8.3) is as follows.
Fig.8.3. Income growth options
with the same payback period
Suppose that when implementing a new business, the payback period of investments is provided for 8 time intervals, and income increases evenly during the operation of the project, i.e. in each time unit, the total income on a cumulative basis increases by the same amount. In this case, we can state that the resulting income component is linear (line FD on the chart). But this pattern of income growth will not necessarily be present in all cases of entrepreneurial business. Everything depends on the scale of the future business, the adopted production technology, the possibility of its development, the qualifications of the personnel used in production, the speed of selling goods to consumers and other factors.
Therefore, the nature of the increase in the income of an entrepreneurial project can and will actually differ from a proportionally linear nature. For example, it could be as shown by the curve FGD or curve FHD. It is easy to understand that with the same payback period of investments (as assumed by the condition of eight time intervals), in all three recorded cases, the nature of the increase in income will differ significantly qualitatively and quantitatively. Best Option for the entrepreneur, of course, there will be one of the three considered that will allow him to quickly return the advanced funds and, therefore, use them to further develop his business. This is the option FGD, which from the very beginning of the operation of the project, the income will grow very quickly and progressively, gradually slowing down by the end of the payback period. The worst option would be FHD, in which the development of the project will initially take place at a slow pace and gradually increase by the time the payback period is reached. Intermediate in quality will be the option FD.
Naturally, the differences in the quality of the payback of advanced investments should be expressed quantitatively, somehow assessed using a specific indicator. This is necessary in order to be able to choose investment options more accurately, to be able to identify existing reserves for improving the use of investments, and to consciously manage the process of mastering a new entrepreneurial business.
The economic meaning of the proposed indicator, which characterizes the dynamics of income growth, can be considered using Fig. 8.4.
Fig.8.4. Income growth options
Figure ABCDEA (has horizontal shading) represents the area of investing investments on a cumulative basis, and the figure FDEF- the area of increase in income from the operation of a new business (has vertical shading). Dot D there is a point of intersection of the lines of investment and income, which will determine the time during which the payback period of the investment comes. Then, according to the schedule, we will have:
line segment AE - duration (term) of investment payback;
line segment F.E. - the duration (term) of the payback period of the object;
line segment AF- the period of time from the start of investment to the start of operation of the project.
To determine the coefficient of increase in income, it is necessary to take the ratio of the area of \u200b\u200bthe figure FDEF to the area of the figure ABCDEA. This condition can be represented as a formula:
(8.11)
where K d the coefficient of increase in income during the operation of an entrepreneurial project;
S d is the area of the figure characterizing the increase in income;
S and - the area of the figure characterizing the dynamics of investments.
Of course, the efficiency of investments, ceteris paribus, will be the higher, the greater the coefficient of increase in income, and the latter will be the more significant, the more significant the numerator S d and the smaller the denominator of the formula S and.
From the figure under consideration, it can be seen that of the three options for increasing income, the top one is the best (it has the largest figure area FDE), then - the middle option, and the worst - the bottom option. At the same time, as can be seen from the figure, all options have the same payback period for investments.
How to determine the size of the areas of the studied figures? For this, two methods can be proposed - graphical and analytical.
To use one or another method, it is necessary to have information about investments and the amount of income in each time interval. This information is necessary and sufficient to determine the growth rate of entrepreneurial income.
With this information, you can build a graph similar to the one shown in Fig. 8.4. It is best to build a graph on graph paper to obtain more accurate results of calculating the desired coefficient and simplify the procedure for determining it.
For the same purposes, you can apply the analytical method of calculating the coefficient of increase in income, using geometric constructions, breaking each complex figure into rectangles and triangles. Then the areas of the obtained figures are determined, and the results are summarized. This problem can also be solved using a computer program.
Let's perform a comparative calculation of determining the coefficient of increase in income with the following initial data.
Let there be an investment project, the implementation of which will require 50 den. units over three time intervals. The project can be implemented using various technological and organizational options that will provide a certain variety in income dynamics. Data on the amount of investment and income over time intervals are given in Table. 8.2.
The indicators presented in table. 8.2, calculated using the author's computer program "Invest-Credit" and reflect the considered theoretical substantiation of the coefficient of increase in income. As can be seen from the table, the coefficients are calculated for six options. Of the first three, the first option has the best result (it has an accelerated income from the start of the project operation), the worst - the third option. It has the lowest income growth rate, since the beginning of the project operation is accompanied by low income, and only towards the middle and at the end the income increases.
Table 8.2
Indicators of investment investments and dynamics of income by time intervals
|
Ordinal number of time interval |
Coefficient growth income |
||||||||
|
investment payments, den. units | |||||||||
|
Options income dynamics | |||||||||
Similar results are noted for the next three options. The best here is the fourth, the worst - the sixth option. However, as can be seen from the table, in terms of the growth rate of income, the first three options are significantly worse than the next options, since options 4, 5 and 6 begin to be used one time interval earlier than the first three. Such a shift in time has a beneficial effect on the calculated indicator, because in this case the denominator of formula 8.11 decreases, and the numerator remains unchanged.
As follows from formula 8.11, a higher coefficient of increase in income occurs when the numerator increases S d and denominator reduction S and . Consider what determines the most favorable ratio between the numerator and denominator of this formula.
This is, firstly, a better preparation of the project for operation through the use of advanced technology, more advanced technology, organization and management of production. Under such conditions, the implementation of the project will make it possible to quickly master the production capacity of the business and receive very high incomes from the very beginning of its operation.
Secondly, the effort to put the project into operation as quickly as possible, while reducing the time from the beginning of the investment period to the start of the operation of the business. It depends on the technology of pre-investment operations and the possibility of combining their implementation with the operation of the project itself.
In conclusion, it should be noted that the indicator of the growth rate of income is devoid of independent significance, but is only an additional indicator of the effectiveness of investments, the use of which allows you to clarify the decision being made and reveal the existing reserves for increasing the return on investment.
ROI is an index that shows the relationship between the costs and the planned profit of the project.
This indicator is calculated:
PI = NPV/IC
- P.I. ( Profitability Index) – investment project profitability index; NPV ( Net present value) – net discounted income;
- IC ( Investment Capital) is the initial investment capital spent.
If the profitability index is 1, this is the lowest acceptable indicator. Any value below 1 indicates that the net profit of the project is less than the initial investment. As the value of the index increases, so does the financial attractiveness of the proposed project.
The profitability index is a valuation method applied to potential capital expenditures. This method divides the projected capital inflow by the projected capital outflow to determine the profitability of the project. The main feature of using the profitability index is that the method ignores the scale of the project. Therefore, projects with large cash inflows may show lower index values in the calculations, since their profits are not so high.
NPV - Net Value of Investment or Net Real (Present) Value of Investment
NPV = PV - Io
- PV- the current value of the cash flow;
- io- initial investment.
The above NPV formula simply shows cash income.
Calculating the planned net worth of investing in a business is not easy. This is due to the fact that money depreciates over time (inflation occurs). Therefore, $1 earned now cannot be equated to $1 received a year from now. In order to compare the received profit with the predicted one, you will need to use indexation factor.
When investing, it is believed that the faster that same $1 is earned, the more valuable it will be the profit received in the future.
- I is the amount of investment in the t-th year;
- r is the discount rate;
- n is the investment period in years from t=1 to n.
Investment value: initial investment and additional capital costs
The discounted projected cash outflows represent the initial capital expenditures project.
The initial investment is only cash flow required to run the project.
All other costs may occur at any time during the life of the project and are included in the calculation using the enterprise's discounted net income. These additional capital costs may affect tax or depreciation benefits.
Decision Making - ROI Index
The return on investment index (PI from the English Profitability Index) should not have a value less than one. If so, then it is necessary to create conditions for its increase.
- PI > 1. If the ratio is greater than one, it indicates that the expected cash inflows in the future exceed the forecasted discounted cash outflows.
- PI< 1. A value less than one indicates that the expenditure of funds will be greater than the projected profit. In this case, you should not run this project.
- PI = 1. A value of one indicates that any gains or losses from the project are minimal. Therefore, the project will not attract the attention of investors.
When using the profitability index, projects are considered, the value of which will be more than one.
The name does not mean profit!
As a rule, the most stable and profitable investment brought by companies that produce everyday products. And high-tech innovative organizations can often bring only loss.
Wealth is the right investment!
Most Owners large companies and networks, invest their savings in investments. Thus, they protect themselves from possible adverse situations.
