Every time we are about to start a business, develop a new product, opening a new branch, acquire new machinery, breaking into a new market, or enter a new category of business, it is necessary to evaluate these projects in order to meet their viability , or to compare with other projects so you can choose the most attractive.
Let's look at the main methods to evaluate an investment project:
Return on Investment (ROI)
The rate of return on investment (ROI for short) is a financial indicator that allows us to measure the profitability of a project, ie the relationship between projected profits and investment.
The ROI formula is:
ROI = (Utilities / Investment) x 100
If the ROI is positive the project is profitable (the higher the ROI a higher percentage of capital to be retrieved), but if it is less than or equal to zero, the project is not profitable because if they start losing money invested .
For example, if the total investment is U.S. $ 5,000, and the total expected profit gain is U.S. $ 10,000, the ROI using the formula:
ROI = (10000/5000) x 100
It gives us a ROI of 200%, which means that the project is profitable and you get a return of 200%.
NPV and IRR
The NPV and IRR are other financial indicators for assessing the profitability of a project, but unlike the previous indicator, taking into account the value of money over time.
The net present value (NPV) measures the profit a project will deduct the amount of the investment at the present value of total projected cash flow.
The NPV formula is:
NPV = BNA - Investment
Where the net present benefit (BNA) is the present value of total projected cash flow, which has been updated by a discount rate (rate of opportunity, performance or minimum expected return).
If the NPV is greater than zero, the project is profitable because it will comply with the expected rate and also get an additional profit, equals zero if the project is also cost effective as it will comply with the expected rate, but if less than zero the project is not profitable because they will not meet with the expected rate and also will be losing money invested.
While the internal rate of return (IRR) is the maximum discount rate can have a project to be considered profitable.
To find the TIR rate must be found that allows the BNA that investment equals (VAN zero).
A rate higher than the IRR that the project would not be profitable because the BNA would be less than the investment (the higher the lower rate would be the BNA with respect to investment), while a lower rate that would mean that the project IRR would be even more profitable (the lower the rate the higher the BNA with respect to investment).
The breakeven analysis is the analysis of the point of activity (turnover) where revenues are equal to cost.
The breakeven formula is:
Pe = CF / (PVU - CVU)
CF: fixed costs.
PVU: unit selling price.
CVU: unit variable cost.
Sales equivalent to breakeven would mean no gain or loss, sales above the mean breakeven earnings and sales below breakeven mean losses.
For example, if the price of each product to be marketed is U.S. $ 12, the variable cost of each product is $ 8, and the fixed costs of the project amount to U.S. $ 6,000, according to the formula of the equilibrium point:
Pe = 6000 / (12-8)
It gives us a balance of 1500 units (in monetary units would be 1500 x 12 = U.S. $ 18,000), which means that from the sale of 1501 units newborn would be starting to generate profits, while sales of less than 1500 units imply losses.
The cost-benefit analysis is the analysis of the relationship between costs and benefits associated with an investment project.
The formula for the cost-benefit is:
B / C = VAI / VAC
B / C: cost-benefit.
VAI: present value of the net income or profits.
VAC: present value of investment costs.
If B / C is greater than unity the project is profitable because it means that the benefits will outweigh the investment costs, but if it is equal or less than unity, the project is not profitable because it means that benefits will be less than or equal investment costs.
For example, if the total benefits expected to be obtained for a period of two years is U.S. $ 20,000 (expecting a rate of return of 12% per year), and the total investment costs is expected to have for that same period is U.S. $ 16,000 (assuming a rate of interest of 20% per year), using the formula of cost-benefit:
B / C = (20000 / (1 + 0.12) 2) / (16000 / (1 + 0.20) 2)
It gives us a cost-benefit ratio of 1.43, which means that to be greater than unity, the project is profitable (for every dollar invested in the project will get $ 0.43).