When reading other people’s business plans or talking to banking experts, I long for the days when no one really knew what discounting cash flows, compounding interest, or, for example, how to account for the risk premium. What it is and how to count correctly, now no one really knows, but the faith has already been accepted. Hundreds of textbooks and millions of expert opinions have been written.

A thousand years ago, no one knew why it was raining and thunder. They simply put a wooden idol on the temple, called it the God of thunder and rain, and prayed to themselves. Why go into any details? There is an idol, because there is thunder. Thunder is because there is an idol. What else is unclear?

The investment and financial market now has the same idols, and the accepted methods of evaluating the effectiveness of business plans are considered the ultimate truth. At the same time, very few people try to delve into the details and explain something. Not because they do not know or do not want to, but because as soon as the business community reaches the meaning of all these financial indicators of investment efficiency, all credit and investment mechanisms will have to be deployed 180 degrees.

Risk premium for the discount rate (applicable to post-Soviet countries). Has anyone tried to give an algorithm for calculating this very premium, so that it would be clear, clear and concise as, say, haiku? No. No one tried.

There is a clear bias in investment management. Either in the direction of mathematicians, or in the direction of marketers. Almost every Manager had to make decisions that involve starting a new investment project, expanding an existing business, or replacing depreciated fixed assets. As a rule, there is always a need to attract external debt financing. We are beginning to systematically Spud banks, investors, credit and investment intermediaries, and other public.

What are the main criteria for evaluating investment projects?

Economic efficiency, financial viability, marketing and technological components, professional experience of the project initiator, the presence of a team and human resources, and so on.

At the time, I had to run around the credit committees of banks (and not only Ukrainian) with business plans for their investment projects. It is characteristic that almost every such financial institution set its own requirements for investment documentation and key financial performance indicators. As a result, I was so fed up with all this that I began to calculate all the world-famous coefficients and indicators in the financial model of each business plan. Fortunately, this is not difficult. Basically, formulas at the high school level (multiply, divide). Better more than less. For everyone – tables and indicators for every taste.

We all know where the legs of all these banking business valuation standards are coming from. Newly arranged graduates of financial Institutions want to show off in front of their superiors. In investment banking, which perversely accepts the American trends of corporate standards, there is such a phenomenon as “commitment” with eternal staff time pressure. And since the main task is to bend the client to additional paid services, then they invent outrageous and often quite senile requirements for business plans. Well, the national mentality plays a significant role. How are we? Every gopher in the field is an agronomist.

Simple example. There is such an indicator as the current ratio (CR).

This is the ratio of current assets to short-term liabilities. A useful indicator that can be used to quickly assess whether an enterprise can quickly repay short debts in its business activities. If you know the sales policy (prepayments, deferrals), the conditions for purchasing raw materials and the use of Bank overdrafts, it is quite easy to calculate.

But why then require the client to calculate the absolute liquidity ratios (Cash ratio) or quick liquidity (Quick Ratio)? The same, but side view, and taking into account the assumption that the company will not be able to return the accounts receivable in time. This is short money, and it makes absolutely no sense to display it in a business plan that has the scale of calculations for 10 years ahead. But bankers often demand. Why they demand it, they don’t really know themselves. In General – absurd.

Well, enough about high matters and left coefficients.

We all have familiar indicators that everyone who has ever faced the issue of developing a business plan or went to the Bank for a loan probably knows about. This:

Net present value — NPV (Net Present Value)
Payback period – PP or PB (Pay-Back Period)
Internal rate of return-IRR (Internal Rate of Return)
Average rate of return-ARR (Average rate of return)
Modified internal rate of return-MIRR (Modified Internal Rate of Return)
Profitability index-PI (Profitability Index)
All formulas and definitions are described on hundreds of websites, they are taught by students at universities, and all financiers are guided by them. It would seem – axioms that are not even subject to discussion.

In fact, nothing like that.

In order to make it clear, you should explain as simply as possible what the discount rate is. He will continue to appear there constantly. In fact, nothing complicated.

The discount rate is the rate of return on invested capital that the investor expects. In other words, this is the comparative rate of expected income that the investor expects when investing money. By the way, he can simply place them on a Bank Deposit for a certain period.

There are two options for determining the discount rate, for which theorists from the economy have been beating spears for decades (and in the course of protecting the next scientific degrees and forcing students to learn their pseudo-economic nonsense).

1. Global option for calculating the discount rate

First, we use the CAPM project risk assessment model. It looks like a decision-making model in the “risk-income” coordinates for securities, and is determined by the formula:

Ra = Rf + Q(Rm-Rf);

Ra is the required return of a stock (asset) A;
Rf-risk-free rate of return;
Rm – market rate of return;
Q-coefficient that reflects the correlation between the asset and the market (price and index).

But this is where the circus begins.

In fact, no one really knows what to mean by a risk-free rate, what the market level of return is, what scale to take for calculation, whether this model can be linear (especially in our country), and how correct the correlation coefficient q is.

I advise theorists who are clever on this topic to shake hands and not return to this office again. Theory and practice are different things. The theorists just need to talk, and you need to work.

Well, if the investor really requires, as they say, any whim for his money. Let only data their gives.

In this case, the discount rate is defined as the weighted average cost of capital (WACC), which takes into account the cost of equity and the cost of borrowed funds.

WACC= RA(E/V) + Rd (Z/V)(1-TP),

Yaa – we have already found out that this is from the field of non-scientific fiction.
E — market value of equity (share capital). Calculated as multiplying the total number of common shares of a company by the price of one share;
Z — the market value of the raised capital. Most often, it is determined by the accounting statements as the total amount of loans of the enterprise.
V = E + Z — total market value of the company’s loans and equity;
Rd — the cost of attracting borrowed capital (interest on the loan). Here we should not forget that the credit load is related to costs and reduces the tax burden (a very common mistake)
TP — rate of income tax.

2. Cumulative method for calculating the discount rate

The variant is more adequate, and is determined by the formula:

D = E + I + R,

D — discount rate (nominal);
E — minimum alternative yield (for example, a Deposit);
I-percentage of inflation;
R-risk premium

The risk premium is a separate song. How it should be considered, no one knows. I might as well have published some of my own tables, and in six months they would have been included in the annals of financial analysis. Banks are used to using the Central Bank’s refinancing rate as a basis. I like to mock Bank analysts on this issue, although I don’t know the answer myself. And no one knows. Ask your CFO about the methodology for calculating risk premiums for the discount rate – you will hear a set of meaningless phrases.

The percentages of risks are summed up. According to the theory, we return to the CARM model again.

The calculation of the risk premium is still not well understood even on wall street and is called the phenomenon of the risk premium. The higher the percentage, the higher the risk aversion. By linking these coefficients to the shares of listed companies, many brokers have already gone bankrupt. So, it’s better to forget about this scheme.

Premium for industry risks. Well, that’s easy. This is a supranational risk associated with the volatility of cash flows in different sectors of the economy.

Bonuses related to the risk of poor corporate governance (the presence of conflicts between shareholders, transparency of activities, compliance with the balance of interests). In General, the indicator is a virtual value. The investor knows better what is going on there.

Country risk is published by Standard & Poor’s. this is the risk of inappropriate behavior of official authorities in relation to business.

Premium for non-liquidity of shares. Again, the investor’s problem. In fact, you should forget about the future capitalization and imagine that how much you bought, then sell.

In General, if you are quite smart, then all this is cunningly translated into percentages and summed up.

But as I wrote above, no one knows how to do it correctly.

We will assume that the discount rate has been sorted out. Isn’t there still a lot of unanswered questions?

There are no answers to these questions. There are enough economic theorists trying to present their vision as the only correct one. In fact, this is only personal PR. They get academic degrees, they get jobs with us, and they evaluate our investment projects.

They have one name – “office plankton”.

They are the ones who misinterpret the IFRS rules and try to discount credit projects. Like, if the credit rate is lower than the market rate, then you need to discount. Why? The Bank does not need to (it already gives money in growth). To the borrower-especially. Show the Bank that it will not earn any more money except for crediting the proposed project? In General, delirium of a grey Mare.

Returning to the main financial indicators. All of them are in all textbooks and kind of are an axiom for everyone. Based on these indicators, everyone is used to evaluating both projects and existing businesses. It seems like an immutable truth, but in fact it is complete, completely detached from the practice of nonsense.

Net discounted present income NPV (Net Present Value) or BPD.
The most famous indicator described in monetary terms Is an indicator that represents the sum of the discounted values of the net profit stream given to date. In other words, the NPV is the difference between all cash income and costs that are brought to the current time (the time of evaluation of the investment project). This is the money that the investor expects to receive from the project, after the net profit recoups its initial investment. It has a fairly simple formula:

NPV= – CF0+CF1/(1+D)+CF2/(1+D)2+CF3/(1+D)3+….+CFn/(1+D)n

We sum up all the operating profit for the months of the project calculation, taking into account D-discounting, subtract CF0 – (invested funds) and get our own gesheft. If NPV > 0, the project should be profitable. If NPV < 0, then you should not take it.

But all this is based on textbooks and what is hammered into the head in the form of unconditional reflexes to Bank clerks. At first glance, everything is beautiful, but there are, as they say, nuances.

Nuance the first. Invested external financing (CF0). If we talk about start-up projects, in which we built, launched and successfully work for ourselves, then everything is normal with NPV. And will the above income be correct if, after some time from the beginning of operation of the object, financing for the construction of the second stage of the object is assumed? Very often, investment projects involve stage-by-stage implementation.

Answer. The NPV will not be correct.

Nuance the second. NPV is not able to correctly account for project risks.

The fact is that if you try to put some kind of risk premium in the discount coefficient (D), it will affect both negative and positive financial flows. As a result, NPV can take the most unexpected values. In order not to give tabular examples here, I will try to explain the result. In case of different variant scenarios that have identical initial data, the NPV may take a normal positive value, taking into account other factors, if the risk premium is increased.

And if you take, and for the sake of sport, remove the risk premium from the calculation altogether, leaving everything else, we are surprised to find that the NPV turned out to be negative.

Nuance the third. Without reference to the discounted payback period, NPV makes no sense. For example, for credit projects, the Bank is only interested in the fact that the accumulated profit could cover the interest and interest on the loan until the borrower pays off all the debt.

If, according to the lender’s rules, the duration of loans can not exceed, say, 5 years, and the calculation of the payback period of the project is 5.5 years, then it is not fate (we do not consider the technical issue of re-lending, because the lender is not interested in this at the decision-making stage).

Nuance the fourth. For example, 10 years of the project is a long time. During this time, the Shah may die, and the donkey may die, and inflation may go beyond the forecast values, and the market environment may change. Take into account the initially probable death of the donkey in the calculation of the risk premium – its value will not pull any project.

Internal rate of return (Internal Rate of Return, IRR)
Another indicator that everyone takes as an axiom. This is the value of the discount rate selected by the scientific method, at which the net discounted income (NPV) is zero. In other words, this indicator reflects the break-even rate of profitability of the project.

The financial meaning of the internal rate of return is that investment projects can be effective if the level of return is not lower than the current value of the cost of capital indicator. If the IRR comes out higher than the average cost of capital, including the risk premium, then the project may be feasible. The IRR value can be interpreted as the lower level of return on investment costs. IRR calculation method.

To calculate IRR using discount tables, two values of the discount coefficient D1 < D2 are selected so that in the interval (D1,D2), the NPV = f(D) function changes its value from “+” to “-” or from “-” to “+”.

The formula might look something like this:

IRR = (NPV(D1)*D2+NPV(D2)*D1)/NPV(D1)+NPV(D2)

NPV (D1) and NPV (D2) are net present income values calculated with discount rates D1 and D2

The worst nightmare of any financial Manager is to explain the value of this indicator as clearly as possible to an unprepared investor (and open formulas are often required in calculations).

Manually (for those who like calculations on a calculator), the IRR calculation will turn into an infinite recalculation of the same financial model with a sequential selection of different discount coefficients. The NPV – d graph is created. Where the curve intersects the d axis, this will be the % IRR indicator.

And again the nuances:

Nuance the first. As I said, trying to link the IRR to a mathematical formula causes the template to break. Since this value is relative, there is no clear mathematical definition for it. Accordingly, it is difficult to explain on the fingers of the investor exactly where the IRR percentage came from. For credit committees, I usually carry a sign with me as an attachment that shows the ratio of NPV to the discount rate, in which the NPV has both positive and negative values, and at the same time a visual graph. Sometimes it helps.

Nuance the second. If the project requires additional funding in the course of operating activities (we decided, for example, to build another shop), there will be the same problems as with NPV. Or worse.

There may be several IRR indicators (and they are obviously incorrect), and there may be a situation when the IRR can not be calculated at all.

There is nowhere to go, and you have to bring each new investment (your own reinvestment in fixed assets) to a separate full-fledged financial plan.

Nuance the third. If we consider different options for implementing the same project, the results of NPV and IRR may differ dramatically. For example, this is a common problem in capital construction projects for commercial real estate.

For Example: Option 1. Sale of the object upon its commissioning. We have an operational return on investment, and a high NPV. But the IRR may be below zero.

Option 2. Lease. The payback period is at least 10 years. The yield is low, coupled with high risks. But the IRR will be at the level. It would be a mistake to make a decision based solely on financial indicators in such cases.

Nuance the fourth. The value of money tends to change over time. In particular, banks like to link long loans to indices (Libor, Euribor, etc.). Risks change. The external environment is changing. Accordingly, the investor can change the discount rate annually (or more often).

In this case (and in long projects this is normal), focusing on IRR generally loses any meaning.

Modified internal rate of return (MIRR)
The situation with some IRR problems is partially corrected by introducing such an indicator as the modified internal rate of return (MIRR). This indicator allows us to estimate an adequate rate of return for projects that involve consistent financing over a long period of time (construction projects or, as already mentioned, capital outflow for the launch of the second stage of production).

MIRR is defined as the rate of return at which all expected revenues generated by the end of the project have a present value equal to the cost of all required costs. At the same time, all investments (regardless of their timing) are brought to the beginning of the project, and revenues are discounted at the above WACC rate (weighted average cost of capital).

The advantage is that MIRR has no problems with multi-variant calculations (like IRR).

The disadvantage is that this indicator is not a panacea for the above nuances of NPV, IRR and it should only be used in conjunction with other indicators. Otherwise, you can simply make a mistake.

Real options method or selection Theory (ROV — real options valuation; ROA – real options analysis)
A very limited indicator that can be used only in markets where there are long-term opportunities to exit or partially sell at fixed prices (or there are clear capitalization rates). For example, investment projects in commercial real estate, in which future anchor tenants or hotel operators are still present at the decision-making stage, ensuring that their property fulfills its obligations after the object is put into operation.

According to Tom Copeland (McKinsey & Company), ROV completely eliminates the disadvantages of NPV and will replace it in the future. In fact, under conditions of uncertainty, ROV is no different from NPV, and the use of futures in the CIS commodity markets is limited.

In fact, despite the mathematical justification of the method, which allegedly allows the investor to assess the effectiveness of the project in the long term, I am convinced that we should be talking about other things.

I would not like to challenge the academic opinions of respected McKinsey & Company specialists and global economic luminaries. However, the method should not be so much mathematical as logical prerequisites for future capitalization and exit from the project to achieve certain milestones. For example, an example of an investment project involving the construction of a plant.

Main stages:

conducting the entire range of research
selecting and obtaining the right to use a land plot with the necessary purpose
obtaining technical documentation that allows you to start design and survey work
capital construction design
capital construction
delivery and installation of process lines
organization of production processes
organization of sales networks
creating a successful brand
At each stage, the cost of the project increases by an amount exceeding the amount of investment, taking into account the cost of money, and the project can be conditionally sold. Determining these points (time, cost, revenue estimation, market demand, and development of potential development scenarios for the future buyer) allows you to evaluate the effectiveness of entering the project.

Financial Management Income rate FMRR (Financial Management Rate or Return)
It is rarely used, but it deserves attention. Partially corrects the shortcomings of MIRR. In fact, it is the same as IRR, but the cardinal difference is that the discount rate of the revenue part has a compound interest (1+D) N (alternative names-interest capitalization, circular rate, compounding).

Average rate of return ARR (Average rate of return)
Other names: Average rate of return or discount rate ARR-an indicator described by a simple formula:

ARR= (CF1+ CF2 +CF3+…. + CFn) / Investments*N

CF – total net cash flow
Investments-total investments
N – duration (number of billing periods)

The indicator is simple and convenient, but also has disadvantages. In particular, the time value of money is not taken into account

Profitability index, PI (Profitability index)
The profitability Index (PI) is the ratio of net cash income to investment expenses reported on the same date. PI determines how much income the investor will receive per notional currency unit.

If PI>1, the project is effective.

Well, with a payback period, including discounted (PB, DPB), I think everything is clear. It can be perceived as a barrier period from which NPV begins to accumulate. Calculated from the moment of the first investment expenditure. In itself, it can be important for the investor only to understand how long the invested funds can be withdrawn in full.

For credit projects, the duration of loan payments and interest payments cannot exceed the payback period of the project.

In General, I would like to think that the investment market is slowly overcoming childhood growth sickness. If earlier the effectiveness of investment projects was evaluated based on indicators of positive cash flow, high rates of return, reduced net income and payback period, now any project must be evaluated based on the capitalization of assets, the possibility of effective exit, the possibility of subsequent diversification (following market changes), sensitivity analysis to various negative factors, and much more.

An integrated approach to project evaluation also requires a new approach to financial calculations of performance indicators. Including a clear method of justifying premiums for market, country, and management risk.

Any investor is well aware that every investment project has its own uniqueness. If an investment idea is not sent to the basket after a cursory review due to the apparent inadequacy of the initiator, it has the right to life. This means that it requires a special approach to evaluating not only financial indicators, but also a number of factors that are selected individually for each business plan.

As for financial analysis and the usual performance indicators, such as NPV or IRR, there are questions not only about their appropriateness in General, but also to investment and credit experts who use them to decide whether or not to let money into the business.

Andrew Stadnik
Investment and project company BFM Group Ukraine