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Models and methods for selecting investment projects

Models and methods for selecting investment projects

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The concept of the effectiveness of an investment project is usually invested in the degree of its compliance with the goals and interests of the participants in the investment.

To determine this degree, an assessment is used, while the project can be evaluated immediately by two indicators:

  • its effectiveness as a whole - social (socio-economic) and commercial (financial);

  • the effectiveness of participation in the project - the assessment is carried out to determine the feasibility of the project and the interest of all participants in this.

An assessment of the investment attractiveness of a project is necessary for a company in the following cases:

  • when looking for investors;

  • when choosing the most effective conditions for lending or investing;

  • when choosing the terms of risk insurance.

The pragmatic goal of evaluating investment projects is to provide a detailed answer to three main questions:

  • what is the return on investment;

  • what is the payback period of the project;

  • what are the risks of the project

A well-conducted investment appraisal of a project allows:

  • assess the absolute need for investment and the availability of the necessary conditions for this;

  • choose the best investment decisions;

  • identify factors that can affect the actual results of investment and adjust their effect;

  • assess acceptable risk and return parameters;

  • develop measures for post-investment monitoring.

The project evaluation itself is based on several fundamental principles:

  • consideration and analysis of the project at all stages of the life cycle - from the pre-investment stage to the completion of the project;

  • validity of forecasts of financial flows for the entire billing period;

  • comparability of conditions for comparing different projects to select the optimal solution;

  • the maximum and positive effects of the project implementation.

  • taking into account the time factor;

  • accounting for future financial costs and revenues;

  • taking into account the most significant consequences of the project implementation;

  • taking into account the interests of all project participants;

  • assessment of the impact of inflation;

  • assessment of the impact of implementation risks.

Evaluation of the effectiveness of an investment project consists of several stages:

Stage 1. Determining the goals and purpose of the investment project

In the general case, the purpose of an investment project is to determine the total investment and production costs, determine the attractiveness of the project from the point of view of investors, identify the financial solvency of the company, assess the risk of investments and justify the expediency of participation in the project of investors and partners.

Stage 2. Cost analysis

This stage consists of two activities that analyze investment and production costs, including their calculation and budgeting, the distribution of financing by project stages, and a comparative profitability analysis.

Stage 3. Evaluation of the effectiveness of investments

In the first part of the stage, the calculation of project performance indicators as a whole is carried out, and in the second part, an analysis of the effectiveness of participation in the project, including determining the composition of participants and choosing a project financing scheme. The first part of the assessment may reflect the social consequences of the project implementation and its financial consequences for the federal and regional budgets if they are involved.

Stage 4. Formation of the financing strategy

It is divided into several sub-stages, including the identification of sources of financing, the composition of potential investors, the conditions for their attraction, the rationale for choosing an investment scheme, the identification of the consequences of its implementation, the calculation of the consolidated cash flow to finance all project costs.

Due to resource constraints, a business typically cannot handle all projects simultaneously, so deciding which project or portfolio will maximize the return on investment becomes necessary.

It is here that the methods of choosing an investment project come into play, which can be conditionally divided into two categories:

  • Methods for assessing benefits;

  • Limited optimization methods.

Benefit measurement is a group of methods for assessing the investment attractiveness of a project based on determining the current value of the outflow and inflow of funds. Cost benefits are calculated and then compared with other projects to make a decision. In the economic literature, this group of methods is often defined as a cost approach.

A group of limited optimization methods, also known as the "project selection math model", are used for larger projects requiring complex and complex mathematical calculations.

There is a rule of thumb: for small projects that are not very complex, it is helpful to use the benefits measurement model (cost approach), while if it is a large complex project, the method is better suited to limited optimization.

A set of fundamental economic, statistical, and dynamic methods

The ratio method is based on the assessment of the ratio of benefits and costs

The cost-benefit comparison is the ratio between the present value of an inflow or the cost of investment in a project (capital cost) plus the value of the current outflow (current cost). Projects with a higher value or lower cost can usually be prioritized.

Economic Valuation Model (Economic Value Added - EVA)

Economic Value Added is a performance measure that shows the return on capital. The indicator is net profit after taxes and capital expenditures (“gross profit”). Theoretically, it is rational to choose the project with the highest economic value added. EVA is always expressed in absolute terms, not as a percentage.

Scoring model

The scoring model is a combined method for assessing the investment attractiveness of a project. The expert commission determines the relevant criteria, weights them following their importance and priorities regarding the conditions for implementing a particular project and the interests of the participants, and then summarizes the weighted values. After the evaluation of these projects is completed, the project with the highest score is selected.

Payback period estimation

The payback period is the ratio of the total amount of money spent to the current moment (capital and current investments invested in the project) to the average revenue for each (small) period. The indicator reflects the time required to recover the costs invested in the project. The payback period is the primary method for selecting a project. It determines the time frame required for the return on investment.

When the payback period is used as a project selection method, the project with the shortest payback period is preferred because the organization can recover the initial investment more quickly and use it for further investment or production activities. However, there are several limitations to this method:

  • It does not take into account the time value of money;

  • Benefits accrued after the payback period are not taken into account;

  • it focuses more on liquidity and ignores profitability;

  • Risks associated with individual projects are ignored.

Net present value (Net Present Value - NPV)

The net present value is the difference between the cash inflow's present value and the cash outflow's present value. The NPV indicator should always be positive; only in this case, the investment project can be considered sustainable.

When choosing an investment project, preference is given to a project with higher NPV values. The advantage of considering NPV is that it considers money's future (discounted) value. However, there are limitations to the NPV-based valuation method - it does not give any picture of the profit or loss that an organization can make by embarking on a particular project.

Internal rate of return (IRR)

The internal rate of return is the rate at which the net present value is zero when the outflow's present value equals the inflow's present value. The internal rate of return is defined as the "annual effective rate of return" or "discount rate" that makes the net present value of all cash flows (both positive and negative) from a particular investment equal to zero. IRR is used to select the project with the best return; the one with the higher IRR is preferred.

When using IRR as a project selection criterion, organizations should keep in mind that it should not be used solely to estimate the cost of a project. A project with a lower IRR may have a higher NPV, and assuming there is no cash investment cap, a project with a higher NPV should be selected as this increases shareholder returns.

Life cycle cost calculation

The life cycle cost calculation includes all project costs throughout its entire life cycle. Government agencies mainly use this method to select large contractors.

Opportunity cost

Opportunity cost is a key economic concept that expresses the fundamental relationship between scarcity and choice. A possible cost in project management is the cost of another project, which is considered when choosing. During project selection, a project with a lower opportunity cost is selected.

The idea of opportunity cost is based on limited results when resources are not available in sufficient quantity to meet needs in their entirety. The manufacturer must decide what he wants to produce from the available resources.

For example, if he decides to make book paper from tree trunks, another product will not be made from the same trunks. For example, a wooden school building will not be built. However, many products are needed and could be produced using the same resource. Solution cost thus becomes an essential factor to consider when scoping or selecting a project.

In decision-making, the opportunity cost is usually the difference between the net cost of the chosen path and the net cost of the best alternative that was not chosen. This concept is also relevant to investment management, where the opportunity cost is the lost value of an opportunity that was not realized due to a different investment decision.

Thus, the lower the opportunity cost, the more preferable the project since it is undesirable to miss out on large opportunities compared to the baseline scenario.

When considering opportunity costs, there is an opportunity to make adjustments to reduce costs or optimize future efforts. Considering opportunity costs does not reduce or change costs but makes costs more explicit so that the investor can manage them appropriately.

In general, the assessment of the investment attractiveness of the project should be considered a problematic task aimed at achieving a balance of interests of the parties.

The complexity of the task is due to several factors:

  • time risk;

  • mode of investment activity;

  • optimism bias;

  • increasing the scale of projects.

Thus, the assessment of the effectiveness of investments is given as a conclusion based on the analysis of performance indicators. In practice, there are several methods for assessing the attractiveness of investment projects, and hence, several leading indicators are a particular set of indicators.

This set includes indicators of financial and economic evaluation of the effectiveness of investments, indicators for evaluating their social effectiveness, indicators for evaluating the company's investment potential, and a risk assessment system.

Each method is based on the same principle - as a result of the project. The company must make a profit, while various indicators make it possible to characterize the investment project from all sides and meet the interests of various groups of people involved in the investment.

In practice, two groups of assessment methods are usually used, with the help of which the listed indicators are determined.

Non-parametric methods for evaluating investment projects

Among the qualitative (non-financial) investment decision methods are optimization and matrix methods, etc. One of the most common and straightforward problems is linear optimization or linear programming (LP). This is a linear objective function optimization problem with linear equality and inequality constraints.

The simplex and interior point methods are the most famous and successful methods for solving linear programming. NLP can be solved using the gradient search method and approaches based on Newton's (interior point and sequential quadratic programming) method.

Let's consider the areas of application of these methods in the process of making an investment decision in more detail:

Health, Environment and Safety Risk Assessment Matrix (J. Schumpeter, 1980).

The development of a risk matrix (HES) involves the involvement of a multifunctional team to identify possible major accident scenarios and assess the likelihood and severity of their consequences. Design alternatives are evaluated for each accident scenario, and the residual risk is evaluated after consideration of prevention and mitigation measures.

Decision Matrix (developed by S. Pugh, 1957).

The decision matrix is a qualitative method for selecting an investment option, which involves the development of a matrix in which the rows contain evaluation criteria, and the columns contain alternatives for choosing a project. This is the best option for a high-quality project selection with maximum efficiency.

Hierarchy Analysis Method (Analytic Hierarchy Process - AHP; developed by D. Saaty, 1978)

Compared to decision matrices, AHP is superior because it structures the evaluation criteria into a hierarchy that matches the project's overall goal and provides a mechanism for assigning weights to the evaluation or rating criteria. It is most suitable for large-scale projects with few critical decision criteria.

Object-Based Image Analysis (OBIA; developers Messner and Sanvido, 2001) for organizing information architecture

Thus, when an investor develops a choice-based decision, deciding how the investment will be made is essential. This decision is usually made based on an ROI analysis.

The role of an investor or analyst is to manage risk, maximize returns, and manage budgets to minimize costs. These two activities maximize the return and minimize the project's opportunity cost.

But there are non-financial benefits that an investor must consider when choosing an investment option. The investor should be able to use different methods and consider a wide range of internal and external environmental factors.

Each design alternative is assessed using a set of criteria for meeting the desired specifications, and the degree of compliance is assessed and compared.

Project success is guaranteed when project evaluation criteria are measured, and the evaluation process is structured and carefully implemented. On the other hand, project selection decisions must be consistent with the organization's mission and business strategy. Project selection decisions provide confidence that budget, time, and technical requirements will be met to ensure projects are cost-effective and cost-effective and succeed in the operating environment.

When a commercial organization plans to invest in projects, deciding how the investment will be made is essential. This decision is usually made based on an ROI analysis. As a rule, earnings from profits are risky because they are earned in the future.

Therefore, the return on profits must be risk-adjusted. The opportunity cost measures the return difference (after risk adjustment) between one investment opportunity and the next best opportunity competing for capital.

The final decision on the project's investment attractiveness depends on its financial viability and assessment of resistance to the most significant risks.

We can say that balanced and balanced investment decision are of a compromised nature and provide a balance of elements associated with the project, including:

  • availability factor. It is necessary to decide whether the real benefits of the project are achievable in the existing conditions;

  • return on investment (ROI) factor. It is essential to clearly understand that the project is highly likely to provide a return on investment at a level not lower than a given indicator of the internal rate of return;

  • portfolio effect. Understanding how much an investment decision fits into the organization's broader set of investment decisions and whether they support or exclude them/conflict of interest is essential.

Thus, project selection can be done in several ways. An organization should try different methods and consider a wide range of factors before choosing a project as precisely as possible that the best decision is made for the company.