Net Present Value
NPV compares the present value of expected future cash flows with the initial investment.
A positive NPV generally indicates that a project is expected to create value at the selected discount rate.
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Investment Analysis
Learn how businesses and investors evaluate investment opportunities using cash flows, returns, risk and practical financial analysis.
INVESTMENT ANALYSIS
What is investment analysis?
Investment analysis is the process of evaluating an investment opportunity to determine its potential return, risk and financial attractiveness.
In corporate finance, investment analysis is particularly important when a business is deciding whether to invest in a long-term project, asset or expansion opportunity.
Common investment appraisal techniques include Net Present Value, Internal Rate of Return and Payback Period.
INVESTMENT APPRAISAL
Key investment analysis methods
These methods help analysts evaluate the financial attractiveness of investment opportunities.
Internal Rate of Return
IRR is the discount rate at which the net present value of a project equals zero.
It can be compared with an appropriate required return or cost of capital.
Payback Period
Payback measures how long it takes an investment to recover its initial cash outlay.
It is simple to understand but does not normally capture all cash flows after the payback point.
Risk and Return
Investment decisions should consider both expected financial returns and the uncertainty surrounding them.
Project Cash Flows
Investment analysis depends heavily on identifying relevant initial, operating and terminal cash flows.
Time Value of Money
Future cash flows are affected by the time value of money, which is central to discounted cash flow analysis.
NET PRESENT VALUE
Understanding NPV
Net Present Value measures the value created or destroyed by an investment after considering the time value of money.
Identify the relevant cash flows
Determine the initial investment and the expected future cash flows generated by the project.
Apply the appropriate discount rate
Future cash flows are converted into present values using an appropriate required return.
Evaluate the result
The resulting NPV provides an important indication of the project's financial attractiveness.
INTERNAL RATE OF RETURN
Understanding IRR
IRR expresses the project's implied rate of return based on its expected cash flows.
Estimate the IRR
IRR is found at the discount rate where the project's NPV equals zero.
Compare the rates
The estimated IRR can be considered alongside an appropriate required return or cost of capital.
Consider the wider evidence
IRR should be interpreted alongside NPV, cash flows, risk and other relevant project information.
RISK AND RETURN
Higher potential returns can involve greater uncertainty.
Investment decisions should not focus on expected returns alone. The uncertainty surrounding those returns is also important.
Analysts should consider assumptions, economic conditions, operating risks, financing risks and the reliability of projected cash flows.
Factors to consider
✓ Expected cash flows
✓ Required return
✓ Business risk
✓ Financial risk
✓ Economic conditions
✓ Project assumptions
PRACTICAL PROCESS
A structured investment analysis process
Define the investment
Identify the project, asset or investment opportunity being evaluated.
Estimate cash flows
Identify the relevant initial, operating and terminal cash flows.
Assess risk
Consider the uncertainty surrounding the expected results and key assumptions.
Select an appropriate discount rate
Use a rate consistent with the project's risk and relevant financing considerations.
Apply appraisal methods
Use NPV, IRR, payback and other relevant techniques to evaluate the opportunity.
Make the decision
Combine quantitative results with strategic and qualitative considerations.
CORPORATE FINANCE CONNECTION
Investment analysis and corporate finance
Investment appraisal is a central part of corporate financial decision-making.
Capital Budgeting
Long-term investment opportunities can be evaluated using capital budgeting techniques.
Explore Corporate Finance →Financial Statements
Historical financial information can provide context for understanding a company's financial position.
Financial Statement Analysis →Financial Ratios
Ratio analysis can provide additional information about profitability, liquidity and financial risk.
Finance Ratio Analysis →
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