Investments are made with an expectation to return more money. Risk and Return goes hand in hand. Investments decisions could range from capital budgeting decisions to corporate decisions like Mergers and Acquisitions. Typically, Investment committees are set up to overlook such investment decisions.

How do you evaluate your returns?

A sound investment decision depends on the appropriate usage of data affecting investment and choosing the right technique to measure the rate of return. Sometimes it is necessary to use multiple methods to measure the returns. An investor should evaluate an investment in terms of the expected return and the risks involved.

The purpose of this article is to discuss the various methods to measure the return on investment.

1. Payback Period:

In the above example the company recovers its original investment between Year 3 and Year 4. After three years, 2,000 is still unrecovered. Since the Year 4 cash flow is 8,000, it would take a quarter of the Year 4 cash flow to bring the cumulative cash flow to zero. So, the payback period is three years plus quarter of the Year 4 cash flow, or 3.25 years.

Despite its simplicity, it has disadvantages. The method measures payback and not profitability and risk of the investments. It also ignores the time value of money and without seeing Time Value, it would be meaningless to determine the worth of the investment.

However, there are refined versions of the payback period called Discounted Payback Period. This method partially resolves the weakness of the payback period by considering time value using discounted cash flows. The discounted payback period is 3.83

2. Internal Rate of Return

The internal rate of return (IRR) is often used in capital budgeting and security analysis. The IRR is a rate at which the net present value of all cash flows equals zero. In other words, IRR is the annual growth rate an investment is expected to generate. Cost of capital is used as a benchmark rate to compare IRR and any project with IRR greater than cost of the capital is considered profitable and hence pursued.

Analysts generally compare IRR against prevailing rates of return in the securities market for benchmarking. Projects are evaluated based on IRR comparing returns as per various scenarios to the required rate of return.

IRR can be used to compare two projects with similar time frames, predictable cash flows and comparable risks, however IRR works only when all the future cash flows are positive. This will be discussed in the next article. Often the discount rates are expected to change over time and IRR has to be used in conjunction with other methods such as NPV in such scenarios.

3. Net Present Value

Net Present Value (NPV) is the summation of the present value of net cash flows over a time horizon discounted at a specific rate. The initial investment or any investments during the project are denoted by a negative sign and the cash inflows are denoted by a positive sign. the net cash flows are calculated and discounted at a specific rate and are termed as present value of future cash flows. The sum of all the cashflows gives us the present value of the project. Generally, the project is profitable or acceptable if the NPV is greater than Zero. In short, the net present value is the difference between the project cost and the income generated by the project.

The advantage of using the NPV over IRR is that multiple discount rates can be used while evaluating NPV. Each year's cash flow can be discounted at a different discount rate based on the cost of financing, expected interest rates at that time or any relevant parameter that influences the cost of capital or finance, making NPV the better method.

The NPV can be used in various scenarios ranging from evaluation of an investment in a capital project, merger or acquisition of companies. The NPV with positive values would increase the value of the company for the shareholder. However, since the method relies on projected cash flows and discount rates. An estimation error could lead to misleading NPV results.

4. Profitability Index

The profitability index is a measure of a project's or investment's attractiveness. The Index is calculated by dividing the present value of future expected cash flows by the initial investment amount. The PI relates closely to the NPV method. A PI greater than 1.0 is considered to be a good investment.

5. Generally, this method is used to rank mutually exclusive projects where there are capital constraints and capital rationing is required to be applied. The PI indicates the value you are receiving in exchange for one unit of currency invested in the project. Projects having greater PI are selected. The only Strategic investment with no expectation of a positive returns:

Some of the projects are pursued not based on their economic viability, but as part of a strategic plan. For example,

• to accelerate market access for the target’s (or buyer’s) products,
• to consolidate to remove excess capacity from industry and improve competitive behaviour
• to gain access to technology, etc

Sometimes government projects are undertaken to meet socio – economic objectives even when they are economically not viable.

Despite flaws that can lead to poor investment decisions, some methods will likely continue to be used widely while evaluating investments because of its strong intuitive appeal. Executives and Analysts should at least cast a sceptical eye at the measures before making investment decisions and at best derive returns using more than one method to confirm the end results.