Numerical models for project selection

Proper selection of investment projects is one of the most important items in the long-term struggle of any organization to survive in turbulent environmental conditions. We read in the press every day about new investment projects in the field of construction: the General ME group has decided to build a 30 km long bridge between Yemen and Djibouti; Microsoft has decided to invest in the Ford automotive industry on console in-car entertainment projects; the Chinese government has decided to suspend the project of building another bridge over the Yan-Ceng-Yang. How to make the right decision and enter large investments? Is it possible to make a realistic decision, when it comes to such large projects? Once made, can we change the decision and if we can, how? These issues influence the decision to choose the right model for project selection.

NUMERICAL MODELS: PROFIT / PROFITABILITY

A large number of organizations use models to analyze projects and select them based on profit and profitability.

PAYBACK PERIOD

The payback period is the quotient of the initial investment and the assumed cash inflow from the project. It represents the time period for which the investment will return. This type of calculation is very simple and represents a calculation that did not take into account all environmental factors, so it must be supplemented by some method, in order to be valid.

RATE OF RETURN (ROI)

This type of analysis is often used in economics, but it is also applicable to projects, because it should indicate how much the investment has earned or how much money has been lost on the investment. With this approach, it is easy to see how much the project will earn in relation to the money spent on it. As an example, it is easy to determine in which branch of industry the return on money is the largest and which project is the most promising.

Return on investment period = $ 100,000 / $ 25,000 = 4 years

It represents the quotient of the net inflow from the project and the value of the investment. If we say that we will sell one thousand two hundred square meters of office space at a price of 2,500 euros on average per square meter, then the net inflows will be 3,000,000 million euros. The construction of such a complex costs us 580,000 euros with the cost of obtaining the location, then our rate of return is as follows:

Return on investment = 3,000,000 / 580,000 = 5.17 (517%)

NET PRESENT VALUE (DISCOUNTED CASH FLOW)

Net present value belongs to a group of criteria that are formed with the help of the technique of discounting money. Under the criterion of net present value, we mean the sum of discounted net inflows that are realized in the period of exploitation of the investment (total life of the investment). This criterion for project evaluation is obtained according to the formula:

NPV – Net present value for the project;
Ft – Cash inflow over time;
k – Required rate of return, and
A0 – Initial amount of invested money (because it is an outflow of money, it will be a negative number).

However, our budget would not be correct if we did not include inflation in the net present value, so we add:

pt – assumed inflation rate. To make it clearer to us how this calculation is used, we will use an example. We will invest 50,000 euros for our investment in the new service of the company. The expected inflow of money over a period of 8 years is 12,500 euros per year. The required rate of return is 15 percent, and the inflation rate is 3 percent annually. Here’s what we get:

In this case, the present value of the inflow is higher than the present value of the outflow, the net present value of the project is positive, and it is concluded that such an investment pays off.