ROI, IRR, NPV,…

In this article I will discuss different methods to evaluate an investment or a project that involves capital expenditure (CAPEX). At the end, I will compare all methods and discuss advantages and shortcomings of each.

ROI

The Return On Investment shows, how much profit you make on your initial investment. An example:

	Year 0	Year 1	Year 2	Year 3	Total
Cash Flow	-10	0	+10	+10	+10

If project or investment has ROI of 100% , the profits cover the initial investment in full. However the ROI does not consider the time it takes to cover the initial investment, nor the cost of capital.

Cash multiple (mltp)

The Cash multiple is often used in private equity and venture capital. It is a very simple expression of an investment return, where investment outcome is considered as a multiple of the initial cash investment. The multiple indicates the size of the investment exit, i.e. how many times the payback covers the initial investment.

	Year 0	Year 1	Year 2	Year 3	Total
Cash Flow	-10	0	+10	+10	+10

A multiple of 2x indicates that the initial investment doubles during the investment horizon. However, same as with ROI, the multiple odes not consider the time (value of money), nor cost of capital.

Payback period

The Payback period answers the question, how long it takes to recover your initial investment. The Payback period is important velocity indicator. Besides investments, it is often used in sales & marketing (advanced analysis of LTV, CAC), or common expenditures in operations and production.

	Year 0	Year 1	Year 2	Year 3	Total
Cash Flow	-10	0	+10	+10	+10
accum.	-10	-10	0	+10

Calculation of Payback period is very simple, however it does not consider the required capital (i.e. profitability), cost of capital, or time value of money.

Economic value added (EVA)

The Economic value added goes a step further and considers the cost of capital associated with the initial investment. In the following example, let’s consider the cost of capital 20% p.a. The 20% will be applied to the initial $10 investment for each year until the exit (year 3). Imagine it as an interest on the loan when making making the investment.

	Year 0	Year 1	Year 2	Year 3	Total
Cash Flow	-10	0	+10	+10	+10
Cost of capital*		-2	-2.4	-2.88	-7.28

The economic value added helps to evaluate projects or investments on their absolute profit after the cost of capital. A positive result means, that the investment will cover the cost of equity and debt, and will contribute to company’s net profits.

EVA does not indicate the profitability, i.e. $2.72 on $10 investment is a good results, but $2.72 on $50 is less good. It also does not tell you when the investment will return.

Net present value (NPV)

Net present value is one of the most popular methods in capital budgeting. It discounts future cash inflows by the cost of capital and compares it with the initial investment. In the following example I will use 20% cost of capital;

	Year 0	Year 1	Year 2	Year 3	Total
Cash Flow	-10	0	+10	+10	+10
PV*	-10	0	+6.9	+5.8	-2.7

Only projects with positive NPV (>0) are worth investing in, as they will cover the cost of capital (equity + debt) and furthermore contribute to shareholder value.

The NPV method is very similar to EVA, however in NPV the cost of capital is applied to the cashflow income and not to the initial investment. The differences arise, when the initial investment is spread over more period.

IRR

In my opinion the IRR is the ultimate evaluation method for projects or investments. The IRR stands for internal rate of return. The method seeks a % by which the discounted returns of the investment match the present value of the initial investment. It is calculated in iterations. In spreadsheets use IRR or XIRR if you want to use precise dates for your cash flows.

	Year 0	Year 1	Year 2	Year 3	Total
Cash Flow	-10	0	+10	+10	+10
discount %	–	–	??	??
PV*	-10	0	??	??	0

The IRR tells you what is the annual rate of return. It is easy to compare it with the cost of capital or alternative investments (yield). It also indicates the time it takes to pay back the investment in full (e.g. 32% is less than 3 years to recover the investment). Finally, it takes into account the size of the initial investment, the payback period, the time value of money.

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Let’s look at all methods and compare it by their advantages and shortcomings.

	ROI	MLTP	Payback	EVA	NPV	IRR
Profit*	yes	yes	no	no	no	yes
Comparability**	yes	yes	no	no	no	yes
Payback time	no	no	yes	no	no	yes
Cost of capital	no	no	no	yes	yes	yes
Time value of money	no	no	no	yes	yes	yes

* The method considers initial investment amount
** The method allows for easy comparison with other investments or market yields