Before starting any investment project, it is necessary to make all the necessary calculations. Perhaps the most important of these are the calculations of indicators that determine the economic efficiency of investments. Based on these indicators, the investor can judge both the feasibility of the project in general and the prospects for participation in it.
One of the most important indicators that can be calculated, probably, by anyone who has something to do with investments, one can name the net present value. In various subject literature you can come across such a name as net present value, which is, in fact, subscript translation from English. But most often it is used the English abbreviation - NPV. The principle of calculating the indicator is to compare the discounted amount of the investment invested in the project and the amount of the discounted profit. The comparison consists in reducing profit by the amount of investment, that is, income is “cleared”.
You may ask: “Why discount value indicators?” The answer is that today's money is without a doubt more valuable than tomorrow's. This phenomenon is determined by the presence of three factors: inflation, the risk of not receiving cash in the future, and the lost profit from using money in alternative ways. Thus, income discounting allows you to take into account the influence of the time factor in the calculations.
Naturally, net present value has a certain performance criterion. The value of NPV must be non-negative. A positive value indicates that the project can be considered effective, and a zero value can correspond to an effective project if it is expected to receive any positive effects other than economic.
The most important problem in determining the net present value is the choice of a discount indicator. The fact is that, depending on the expert’s opinion, with the same cash flows you can get both positive and negative net present value. From this it becomes quite obvious that this indicator is subjective.
An objective indicator is the level of the internal rate of income, since it does not depend on the opinion of the person making the calculations. The meaning of this indicator is that it represents the inherent value of the discount rate at which NPV goes to zero. That is, this is the maximum income that this project is capable of generating in principle. It is important to compare the level of this indicator with the price of capital raised. Obviously, this price should be less than the internal rate of return.
Using net present value, you can calculate another performance indicator - the profitability index. It determines how many units of profit each monetary unit brings, whether it is a ruble, a dollar or something else invested in an investment. Based on this definition, the profitability index can be determined by the ratio of discounted profits to the amount of discounted investments. You can make elementary transformations that will allow you to calculate this indicator as follows: you will need to divide the found value of NPV into discounted investments and increase the result by one. It should be borne in mind that this indicator characterizes the profitability for the entire implementation period, so with its help it is not entirely correct to compare projects of different durations.
The calculation of the above indicators is necessary if you want to judge the effectiveness of the analyzed investment project, but they will not be enough. In any case, it is important to understand that in order to make a decision it is necessary to calculate a system of performance indicators, since only in this case it will be possible to draw the right conclusions.