How to Evaluate the Profitability of an Investment - Pt. 1
Capital budgeting is a process a company undertakes to evaluate potential large projects or investments and decide whether or not to proceed with them.
The construction of a new plant or a large factory in a foreign country are examples of projects that require – as you can easily imagine – a very careful evaluation before being approved or rejected.
The evaluation of these investments goes through the process of so-called capital budgeting, which is based on the evaluation of the incoming and outgoing cash flows of the project, to determine whether the potential returns thus generated meet a profitability objective considered sufficient.
In this way, we try to reduce the uncertainty associated with such initiatives by estimating the probable economic returns of such investments.
The main investment evaluation techniques, each with its pros and cons, are three:
- Payback Period (PBP) for Anglophiles;
- Net Present Value (NPV) ;
- Internal Rate of Return (IRR) .
The logic behind the various evaluation criteria is very simple, and consists of these two steps in sequence:
- estimate of future cash inflows and outflows related to the specific investment project (common to all methods);
- discounting of the various future flows at the reference date of the evaluation, in order to understand if and how much the project is profitable (it is common to the last two methods).
With these assumptions it is easy to understand how capital budgeting can also be used successfully in make or buy decisions, as we will see in the following example, in which we will use the three techniques and discover that each of them has its own qualities, strengths and weaknesses.
But let's get to the heart of the example, and imagine that we are a company that owns a large plant that is now obsolete, so we are faced with the following choice:
- A – repair/modernize the existing system;
- B – purchase a new system.
Repairing the existing plant involves an investment (cash outflow) of 100,000 and, once completed, will allow to produce a certain level of cash flows (inflows) in a given time horizon, which we estimate for example in 5 years.
Purchasing a new plant, on the other hand, involves a double investment, equal to 200,000, which will allow you to obtain – in the same time horizon – a certain level of cash flow (higher than in the previous case as the plant is new and therefore more productive).
It can all be summed up as follows:
If we consider the Payback Period as the decision rule, the entrepreneur should choose solution A, since in this way he would recover the investment in 2 years, instead of 3 as in case B relating to the purchase.
As can be seen from the following figure, in fact, in case A the initial outflow of 100,000 is replenished by the flows of the first two years (50,000 + 50,000), while in case B to recover the initial outflow of 200,000 it will be necessary to wait three years (30,000 + 100,000 + 70,000).
The graphical representation of the 2 alternatives allows us to better understand the logic of the Payback Period, given by the intersection of the initial outflow line with the cumulative incoming cash flow curve.
ADVANTAGES of the Payback period:
- simplicity of calculations
- immediate interpretation of results
DISADVANTAGES of the Payback period:
- does not take into account the time factor
- does not consider flows after the recovery period
In the second part of the article we will understand how the other two evaluation methods work – always continuing with our example – which try to overcome the notable critical issues of the method just seen.