In this chapter we want to talk about financial evaluation and the benefits capture. The major method used are:
- Return of investment
- Present and future Value
- Net Present Value
- Internal Rate of Return
- Paybeck Period
- Cost benefit analysis
Return of investment
The return of investment (ROI) is the potential profitability of ad investment and is the benefit received in relation to the cost.
The forumula is:
ROI = (End value – cost) / cost
Present and future Value
Present Value (PV) and Future Value (FV) are two measure helpful for the initial project selection. The formula are:
FV = PV * (1+r)^n
- PV = Present Value, is the money that you need to spend today;
- FV = Future Value, is the value of the money that you can have in the future;
- r = Interest rate. So, for example, if we invest the liquid money somewhere, the interest per period;
- n = Number of periods. For example, several years.
So with this two formula, you can reply to this question:
If a project require 1000€ now, and it will give me 500€ each year for five years, it’s better to do this project or maybe is better to leave my money in bank at the normal investment rate? For reply to this question i need to know what is the Future Value of my 1000€.
On the other end, you can make even the Reverso example, starting from the future value and finding the present value. But look at it as an easy example.
Example: A project requires 1000€ of investment in a year0 (actual year). In year1,...year4 it will cost 0 for a year, and give back 500€ for a year. In this case, the project will give you back 5x500€ = 2500€ - 1000€ = 1500€ 1500 is the Net Present Value (NPV), in other words, only the gain. On the other hand, the FV of 1000€ if we have an R of 12% is= 1000 * (1+0,12)^4 = 1573€ that it is the NPV because we haven't to spend anything. So, in this case is best to doesn't do the project because 1573 > 1500.
Net Present value
The Net Present Value is the PV minus the cost on each time periods (in the example before we had calculated only an initial investment).
Internal rate of return
By definition internal rate of return (IRR) is the rate at which the project inflows (revenues) and the project outflows (costs) are equal. But if you want to make a simple example, the IRR is like the revenues of the money in a bank account, higher is the IRR and best are the investment in terms of revenues.
The payback period is simple the time that the company need to get back the initial investment.
Cost Benefit Analysis
Is the rate between cost and benefit. The formula is:
CBA = Cost / Benefit