Module 7: Investment analysis
Investment analysis is the systematic process of evaluating investment opportunities to determine
their expected returns, risks, and suitability for specific financial goals. It is essential for capital
budgeting, project selection, and portfolio management.
Key Steps in Investment Analysis
1. Identify Objectives and Constraints
• Define the investment goals (growth, income, safety) and any constraints such as time
horizon, required returns, risk tolerance, and liquidity [Link]+1
2. Gather Data and Forecast Cash Flows
• Project future cash inflows (revenues, savings, resale) and outflows (costs, operating
expenses, investments) for the investment opportunity. Use a detailed cash flow
analysis to get accurate estimates.
3. Determine Discount Rate
• Choose an appropriate rate reflecting the opportunity cost of capital and risk. The
discount rate is used to bring future cash flows to present value terms.
4. Apply Evaluation Methods
• Net Present Value (NPV): Calculate the present value of all cash flows and compare to
the initial investment. Accept projects with NPV > 0.
• Internal Rate of Return (IRR): The discount rate that makes NPV zero. Accept projects
with an IRR above a minimum required rate.
• Payback Period: Time needed to recover the initial investment. Shorter period
preferred (for liquidity), but does not consider TVM or cash flows after payback.
• Profitability Index (PI): Ratio of present value of inflows to initial investment. Projects
with PI > 1 are attractive.
5. Risk Assessment
• Analyze potential risks using sensitivity, scenario, and probability analysis to assess
impact on viability and outcomes. Consider market volatility, project-specific risks,
and broader economic factors.
6. Compare Alternatives and Make Decisions
• Weigh alternatives using the evaluation criteria and select projects that best meet the
objectives and have favourable risk-return profiles.
Time Value of Money
The time value of money (TVM) means that money available today is worth more than the same amount
in the future due to its earning potential and risks like inflation and uncertainty. TVM is the foundation for
evaluating cash flows over time in engineering and business projects.
Present and Future Worth
• Present Worth (Value, PV): The value today of a future cash flow, discounted at a specific interest
𝐹𝑉
rate. Formula:𝑃𝑉 = (1+𝑟)𝑛 where 𝐹𝑉 is future value, 𝑟 is interest rate per period, 𝑛 is number of
periods.[4]
• Future Worth (Value, FV): The value at a specified time in the future of a sum invested today.
Formula:𝐹𝑉 = 𝑃𝑉 × (1 + 𝑟)𝑛
Cash Flow Analysis
Cash flow analysis involves tracking all inflows and outflows of cash over time for a project in order to
evaluate profitability and feasibility. Cash flows are plotted over each period (year, month, etc.), allowing
for calculation of total returns and economic evaluations.
Cash inflows and outflows are key elements in cash flow analysis and financial decision-making.
Cash Inflows
Cash inflow is any money received by a business or individual, increasing available cash resources.
Common sources include:
• Revenue from sales of goods or services
• Returns on investments, such as interest, dividends, or capital gains
• Proceeds from financing activities (e.g., loans, issuing shares, or bonds)
• Sale of fixed assets or property
Cash Outflows
Cash outflow is money paid out by a business or individual, reducing available cash. Common
examples are:
• Payment for raw materials, supplies, and inventory
• Operating expenses (wages, rent, utilities, insurance, transport)
• Purchase of long-term assets (machinery, equipment)
• Repayment of loans or debts, interest payments
• Dividend payments to shareholders
Importance in Analysis
• Net Cash Flow: The difference between total cash inflows and outflows within a given period.
Positive net cash flow means more cash enters than leaves; negative net cash flow means
outflows exceed inflows.
• Cash Flow Statement: Financial reports track and categorize these movements, helping
businesses assess liquidity, operational efficiency, and financial health.
Tracking and managing inflows/outflows ensures a business can meet its obligations, plan
investments, and evaluate alternatives effectively.
Economic Evaluation of Alternatives
This process involves comparing different projects or investment opportunities using financial metrics,
considering the timing and magnitude of cash flows, to determine which option is most economically
advantageous.[2][5]
Capital Budgeting Methods
Capital budgeting is the process of planning investments in projects by analyzing their potential returns.
Essential evaluation methods include:
• Pay-back Period: Time taken for cumulative cash inflows to recover the initial investment. Shorter
payback = quicker recovery, but ignores cash flows beyond the payback point and doesn’t consider
TVM.
Initial Investment
Payback Period =
Annual Cash Inflow
• Net Present Value (NPV): Sum of present values of all cash inflows and outflows over a project's
life.
𝑛
𝐶𝑡
𝑁𝑃𝑉 = ∑
(1 + 𝑟)𝑡
𝑡=0
where 𝐶𝑡 is net cash flow at time 𝑡. Projects with NPV > 0 are considered justified.[6][2]
• Rate of Return (Internal Rate of Return, IRR): The discount rate at which NPV = 0. IRR is
compared to a required rate; the project is accepted if IRR is greater. May be solved using financial
calculators or software.
• Profitability Index (PI): Ratio of present value of inflows to initial investment.
Present Value of Future Cash Inflows
𝑃𝐼 =
Initial Investment
A PI > 1 indicates a worthwhile project.
Method Formula / Concept Decision Rule
Present Value 𝐹𝑉 Higher is better
𝑃𝑉 =
(1 + 𝑟)𝑛
Future Value 𝐹𝑉 = 𝑃𝑉 × (1 + 𝑟)𝑛 Used for comparison
Pay-back Period Initial Investment/Annual Cash Inflow Shortest is best
Net Present Value 𝐶𝑡 NPV > 0, accept
𝑁𝑃𝑉 = ∑
(1 + 𝑟)𝑡
IRR NPV = 0, solve for r IRR > required rate, accept
Profitability Index 𝑃𝑉 of Inflows PI > 1, accept
𝑃𝐼 =
Initial Investment