Investment Analysis Tools

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  • 0:04 Investment Analysis Tools
  • 1:06 Net Present Value
  • 3:18 Internal Rate of Return
  • 4:44 Payback Period
  • 5:42 Lesson Summary
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Lesson Transcript
Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and a PhD in Higher Education Administration.

The key objective of a corporate finance team is to find ways to optimize the company's resources, including how to invest cash. In this lesson, we'll discuss three important tools that can be used to analyze the potential of any given investment.

Investment Analysis Tools

Companies generate cash and profits through operations and investments. Operations just consist of making and selling goods and services. From the corporate perspective, an investment is any expenditure purchased with the intent that it will generate more income than it cost during its useful life.

For example, purchasing stock is an investment because the intention is that the stock will increase in value and can be sold at a higher price at some future date. A new piece of equipment might be an investment as well - the intention is that it will produce something worth more than the cost of the machine.

Of course, the challenge with investments is that we can't see the future and, truthfully, neither can finance professionals that are expert analysts and employed by top companies. But we can use financial analysis to calculate our anticipated return on an investment, and then decide if the assumptions of that model are reasonable enough to convince others that the reward is worth the risk.

In this lesson, we'll talk about three analyses we can do: the net present value (NPV), internal rate of return (IRR), and the payback period.

Net Present Value

Net present value, or NPV, is the total value in today's dollars, of all future income from an investment. The important part of that definition is 'in today's dollars.' Remember, money loses its value over time because of inflation, which means the $1,000 an investment may return five years from now isn't worth as much as $1,000 today. NPV accounts for this by discounting all the future income from an investment based on a given rate and time period. When you have that sum, you simply compare it to how much the investment will cost and if the gain is sufficient, you make the investment.

Let's look at an example. Your company can buy a new t-shirt making machine today for $5,000. You've run the numbers and believe that this machine will produce enough shirts that you will make $2,000 a year for the next seven years. Analyzing this investment is not as easy as just saying 'I can spend $5,000 and make $14,000' (seven years at $2,000 per year). You need to be able to compare the value of that $14,000 in today's dollars.

Mathematically, we do that by using the NPV formula for each year of income, then adding the years together. Here's the NPV formula, in which t is the number of years away the return is realized, i is the assumed inflation rate, and P is the amount of money we'll receive.

NPV Formula

Let's look at that same equation, applied to the numbers we have in our example for years 1, 2, and 7. To calculate the NPV, we would use that formula for each year and add the answers together. That would be about $12,460. So, is it worth $5,000 today to make $12,460? If that return is acceptable to you, then you would deem this a worthwhile investment and buy the machine.

NPV Example

Internal Rate of Return

Oftentimes you'll hear people talk about their 'rate of return.' The rate of return is the percentage per year an investment returns, calculated by dividing the principal amount by the return. So, if someone says 'my retirement portfolio had a 10% rate of return last year,' they are saying the value of their retirement increased by 10% - perhaps from $100,000 to $110,000. When discussing and comparing investments, sometimes it's easiest to figure out their rate of return and compare those.

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