Investment analysis

There many methods to anayze investments. Here are a few:

Techniques which ignore the time value of money

Payback time

The payback time is the time needed to generate incoming cash flows equal to the amount of the initital investment. The advantage of the payback time method is that is very easy to apply. It is often used by companies where liquidity is an issue, and who therefore prefer investments who are earned back quickly.  If two projects with equal investments have different pay back times, the project with the shortest payback time is preferred. In many cases, this is reasonable, because projects with earnings in the long term are surrounded with higher risk than projects with earnings in the shorter term. However, the payback time method has many disadvantages, of which ignoring the time-value of money is the most important one. This can lead to wrong prioritization of investement projects.

Accrual accounting rate of return

The accrual accounting rate of return is calculated by dividing the average yearly profit by the required average investment. It is based on the notion of Return on Investment (RoI). Of course, only revenues and costs are included that direclty relate to the investment. The time considered is the life-time of the investment. Although the accrual accounting rate of return is better than the payback time method because it considers the life-time of the investments, it still does no account for the time-value of money.

Techniques which address the time value of money

Discounted cash flow

The Discounted Cash Flow (DCF) is the method used in the accompanying book. The DCF methods considers all ingoing- and outgoing cash flows related to the investment (including the investment itself). The amounts per contract period (often a year) are discounted by an interest). Usually, the amounts are discounted to year 0, which is the year of the initial investment. By doing do so, the amounts of the contract periods become comparable by taking into the acount the time value of money. An important choice while applying the DCF method is the selection of the interest rate, also called the Required Rate of Return (RRR), or the hurdle rate. The rule of thumb is: the higher the rate, the higher the risk of the investment. The rate should be at least as high as the interest associated with risk-free investments (e.g. state bonds). The DCF calculated should therefore be seen as the reward the invester receives for the additional risk (reflected by the RRR) in comparison to a risk-free investment.

Internal Investment Rate

The Internal Investment Rate (IRR) is the complement of DCF. It calcules the interest rate when all cash flows that occur during the life time of the investment are equal to 0 (of course all the cash flows are discounted). The IRR calculated should be higher than the interest rate of risks-free investements.