Investment evaluation is a critical step for every business to ensure that its resources are spent effectively and its goals are achieved. Evaluation criteria for investments may vary depending on the nature of the business and its industry.
Investment evaluation criteria:
- Payback Period: The total years required for cumulative cash flows to cover the capital investment are considered the Payback Period of an investment.
The payback period of an investment should be as short as possible, and between two investments, the one with the shorter payback period is chosen according to this criterion.
- Easy technique, suitable for a quick assessment.
- Relies on cash flows and, in a rudimentary way, recognizes the time it takes to achieve cash flows.
- Net Present Value (NPV): It uses a discount rate to discount future cash flows, and the difference between the present value of future cash inflows and the present value of the capital investment is called Net Present Value (NPV).
Value (Net Present Value – NPV)
Criterion: If NPV is negative, the investment project is excluded.
The higher the NPV, the better the project.
- Internal Rate of Return (IRR): ): The internal rate of return is the discount rate that makes the Net Present Value zero. In other words, it equates the present value of future cash inflows of the investment with the initial cost of the investment.
Criterion: If IRR is less than the minimum required return, the investment project is excluded. The higher the IRR, the better the project.
NPV vs IRR
- When dealing with investment plans with typical cash flows, the two criteria agree.
- IRR is more easily understood by the average manager or shareholder.
- IRR ignores the size of the investment, while NPV is expressed in absolute values (€).
- In cases of non-typical cash flows (sign changes), there may be multiple IRRs.
- In casesof mutually exclusive projects, the NPV criterion is preferred.
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