Return On Investment
When analysing investment projects someone has to deal with the golden question “is it going to be profitable?”, followed by, “when?”. There are so many ways of answering these questions, but at the moment I’m going to focus on 3, very briefly:
1) Net Present Value (NPV).-
Get all the cash flows the project is going to generate (money invested, money spent, money earned), choose a reference interest rate (i.e. weighted average cost of capital, risk-free interest rate…), discount’em to present, and add’em up. If this value is positive then the project is worthwhile.
2) Internal Rate of Return (IRR).-
It is the interest rate that makes the NPV equal zero (IRR | NPV=0). If this rate is above your reference interest rate, then the project will have a positive NPV. Both measures are complementary, and both accept at the same time the project, rejecting the project at the same time, as well.
3) Pay-back Period.-
It is the time that takes the project to pay itself, so we’re talking from a cash-flow perspective exclusively. So, for instance, if the value is 2.25 years, that means the project will start generating profit after 2 years and a quarter.
When calculating this period I like to first discount all the cash-flows using the reference interest rate, so $1 is $1 for every flow (you know the first principle in finance: how much?-when?).
For easing the calculations I’ve prepared a spreadsheet to help. You can download it from the link below.
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