Gauging Investment

Investment objective are normally defined by the investor. It is not uncommon that one project may be viable to one investor and not viable to another investor. The standard measure is usually the industry benchmark, though this must not be used to condemn a project with a positive net present value.

Tools for gauging the viability of a project

1 – Pay Back Period (PBP)

This is the most basic tool applied by investors to compare projects, or development options. It requires no special skills or industry knowledge to apply. Pay Back Period is the amount of time taken to recoup your invested capital in the project. It is presented as a ratio of the total investment cost to its annual income which is assumed fixed over the life of the project.

  • PBP = (Cost of Project/Annual income) Years.

For example if you invest 10m in a project which earns you 600,000/- per annum with 10% outgoings, your PBP will be computed as follows:

  • PBP = (10,000,000/(600,000-60,000)) Years.
  • PBP = 18.52 years

This can then be compared with other investment options and the industry benchmark. A shorter PBP is an indicator that the project is better.

2 – Return on Investment (ROI)

Return on Investment measures the profitability of the project. Again this is a basic tool applied by investors to compare projects, or development options. It is presented as a percentage of the annual income to the total investment cost.

  • ROI = (Annual Income/Cost of Project) x 100%.

In the above example, the ROI is computed as follows:

  • ROI = ((600,000-60,000)/10,000,000) x 100 %.
  • ROI = 5.40%

Again this can be compared with other investment options and the industry benchmark. A positive return implies the project is viable. A higher ROI is an indicator that the project is better. However conversely, a higher ROI is also an indicator that the project is riskier.

3 – Net Present Value (NPV)

This is a relatively complex computation applied by an expert to determine the viability of a project. Unlike the other tools above, this reflects the real world scenario; that income is not static – rents rise with time and that a project has life – beginning and end. Under the NPV computation, all positive and negative cash flows are projected over the life of the project and discounted to the present and summed up. A positive value implies the project is viable while a negative one implies the project is not feasible. The expert applying this must be conversant with the market of the real estate class .

In the above example, we introduce project life as 5 years and rent growth at 5% per annum. NPV can be computed as in the table below:

Year/Description

Cash Flows

PV @6% NPV
Implement (-) Dispose of (+) Income (+) Expense (-) Net Income

0

(10,000,000)

(10,000,000)

1.00

(10,000,000)

1

600,000

(60,000)

540,000

0.94

507,600

2

660,000

(66,000)

594,000

0.89

528,660

3

726,000

(72,600)

653,400

0.84

548,856

4

798,600

(79,860)

718,740

0.79

567,805

5

14,500,000

878,460

(87,846)

15,290,614

0.75

11,467,961

NPV

7,796,754

3,620,881

The above project with a positive NPV indicates the project is viable. However the figure 3,620,881 lacks comparability element as it is just a number.

4 – Internal Rate of Return (IRR)

Internal Rate of Return refers to the rate of return at the point where the Net Present Value – NPV is zero. This is a fairly complex mathematical concept that involves calculus and guesswork as may be necessary in the application. And not to dampen your hope, it can be computed using computer software or spreadsheets. In the above example, I used Microsoft excel to compute the IRR which is I obtained as13.34%.

You can therefor compare various project IRRs. The higher the IRR the better the investment

5 – Profitability Index (PI)

Profitability Index is also referred to as the Cost/Benefit ratio. It is the present value of all anticipated benefits from an investment divided by the present value of capital outlay – cost.

  • PI = Present value of anticipated investment returns/present value of capital outlay

Again, in the above example (note NPV in 3), this is computed as follows:

  • PI = (507,600+528,660+548,856+567,805+11,467,961)/10,000,000
  • PI = 1.36

PI higher than 1.0 indicates that the project is feasible. This is a useful tool in comparing investment options. PI of 1.0 is an indicator that the rate of return is the same as the IRR.

  1. Very informative blog. Thank you.

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