The elements of an investment analysis

a) NPV (Net Present Value) – compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative.

NPV= C0 + C1 / (1 + r)
C0=investment, C1= cash flow, r=discount rate

b) Payback Period – the length of time required to recover the cost of an investment.

Investment/ yearly cash flow

c) WACC (Weighted Average Cost Of Capital) – Broadly speaking, a company’s assets are financed by either debt or equity. WACC is the average of the costs of these sources of financing, each of which is weighted by its respective use in the given situation. By taking a weighted average, we can see how much interest the company has to pay for every dollar it finances.

WACC = E/V * Re + D/V * Rd * (1 – Tc)

Re = cost of equity
Rd = cost of debt
E = market value of the firm’s equity
D = market value of the firm’s debt
V = E + D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate

d) IRR (Internal Rate Of Return) – You can think of IRR as the rate of growth a project is expected to generate. While the actual rate of return that a given project ends up generating will often differ from its estimated IRR rate, a project with a substantially higher IRR value than other available options would still provide a much better chance of strong growth.

IRRs can also be compared against prevailing rates of return in the securities market. If a firm can’t find any projects with IRRs greater than the returns that can be generated in the financial markets, it may simply choose to invest its retained earnings into the market.

Picture1

In the above formula, CF is the Cash Flow generated in the specific period (the last period being ‘n’). IRR, denoted by ‘r’ is to be calculated by employing trial and error method.

e) Hurdle Rate – The minimum amount of return that a person requires before they will make an investment in something

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