Investment Projects Profitability Analysis
In this article, general lines that should be taken into consideration in the profitability analysis of investments to be made, especially in an economy with inflation and increasing exchange rates, are stated. This article can provide you with a vision about the acceptability of investment projects.
In this article, “How can I decide whether investment projects create financial value? What discount rate should I use when discounting expected future cash flows in investment projects to the present? What is the risk-adjusted discount rate? What is the risk-free interest rate? What is the risk premium? What is the beta coefficient? You can find answers to questions such as.
ABOUT THE ACCEPTABILITY OF INVESTMENT PROJECTS;
In the profitability analysis of investments or projects, the value of the investment is equal to the net present value of the expected cash flows.
If the present value of the cash we will obtain in the future from the projects is greater than the current cash outflow, the projects result in net cash inflow and are profitable projects.
A project creates value only if it generates higher returns than similar investments in financial markets.
In the simplest terms, if the investment we make with some money we have provides a return higher than the market interest rate, this investment creates financial value.
If we invest some money for interest, we can find the future and present value of our money by using the formulas Future Value = Principal x (1 + Interest Rate) Maturity and Present Value = Future Value / (1 + Interest Rate) Maturity.
Net Present Value Method
We use the following formula to find the net present value of the future cash flows of our investments.
NPV = Net Present Value
NA1,NA2… = Cash Flow at the end of the 1st Period, Cash Flow at the end of the 2nd Period…
Discount Rate (r) = Risk-free rate of return + Risk Premium
The discount rate of the investment is equal to the return that could be earned on an investment with equal risk in the financial markets. However, we often have to include risk in this discount rate.
Exchange rate risk, inflation risk, geographical risk, country risk or other uncertain risks cause uncertainty in investment profitability, so the risk should be included in the discount rate we use to discount cash flows, and the Risk Adjusted Discount Rate should be used.
As the risk increases;
- While the present value of the project is constant, expected future cash flows increase,
- If the expected future cash flows of the project are certain, that is, fixed, the present value of the project decreases.
- If we give an example of the first item; While the present value of a factory that produces and sells essential consumer goods as a monopoly is constant, we expect future cash flows to increase.
- If we give an example of the second item; In an environment where exchange rate and inflation risks are constantly increasing, we expect the expected current return of committed, progress-based projects to decrease.
The main logic for us to understand NPV calculations is as follows; Let’s say we have two service contracts with the same contract price and the same contract period. The one with higher risk has a lower present value. or when the present value is fixed, the future value is higher, that is, among two contracts with the same present value and the same amount and the same duration, the expected future return of the one with higher risk will be higher.
Risk Adjusted Discount Rate can be applied to projects with increasing risk, but if the risk decreases over time, we may calculate the value of the project lower than it should be, which will mislead us.
HOW DO I CALCULATE THE DISCOUNT RATE?
According to the Capital Asset Pricing Model (CAPM), the discount rate is found as follows;
- Discount Rate (r) = (Risk-free interest rate) + (Market risk premium) x (Beta)
- Discount Rate (r) briefly consists of the sum of the Risk-free return rate and the Risk Premium.
So, let’s talk about how to determine the risk-free rate of return and risk premium.
WHAT IS THE RISK-FREE INTEREST (RETURN) RATE?
The risk-free rate of return is the interest rate in each country’s currency of the central bank, which has the authority to create that currency. However, since the interest rates of central banks are short-term and are not applied for every maturity, the yields of treasury bills or government bonds in that currency corresponding to the maturity are accepted as the risk-free rate of return in practice. The interest rate valid throughout the life of the asset is the value found by using the 10-year government treasury bonus or bond interest rate in a 10-year project, which is generally valid for companies throughout the life of the project. If we are using a foreign currency, it is the value found using the state treasury bonus or bond interest rate to which the currency belongs. For example, nowadays (November 2018) TR 10-year bond interest rates are 16.69 and US 10-year bond is 3.
WHAT IS RISK PREMIUM?
Risk premium is the value found by multiplying the difference between the market rate of return and the risk-free rate of return by beta.
In other words, the Risk Premium is the risk of the project relative to the general market index, it is the measure that shows the relationship between the changes in the project returns depending on the changes in the return rates of the market portfolio.
For example;
If we have a project with a risk-free rate of return of 16% and a market interest rate of 24%, with a beta of 1.5, the risk premium is (24% – 16%) x 1.5, or 12%.
WHAT IS BETA COEFFICIENT?
Beta (β) shows the relationship of the relevant project (or sector) with market movements.
It is the calculation of how risky the market risk is against the preferred project, or it shows how risky the preferred project is compared to the market.
For example, if the market’s beta is 1 and our project’s beta is 2, when the market gains 10% value, our project gains 20% value, and the same is true when there is a decrease. If the market has a beta of 1 and our project has a beta of 0.1, when the market gains 10% in value, our project’s return increases only by 1%.
Beta is calculated by dividing the covariance between the return of the project and the return in the market (Covariance examines the changes of two variables together) by the variance of returns in the market (variance is the average square of the distance between the average value and each value in the population).
While calculating covariance and variance, in the simplest form, we can calculate covariance in Excel by putting the interest returns of the market and the expected returns of the project in the same periods side by side, and we can also calculate the variance for the returns of the market in the same periods.
Beta coefficient shows the sensitivity (volatility) of the project to market risk.
- If ß=1, the movement of the project return is the same as the market (average risk).
- If ß<1, the movement of the project return is slower than the market (less risky, low volatility).
- If ß>1, the movement of the project return is faster than the market (more risky, high volatility).
However, it should not be forgotten that we reject the social responsibility of businesses by saying that investments that do not create financial profitability are unacceptable. Even though the investment does not create financial profitability and has a lower expected return than the financial markets, sustainable investments are the main responsibilities in the development of our country, reducing unemployment, industrialization, development, transferring the corporate culture to new generations or keeping your values alive.