Introduction to Energy Economics

Lecture 2.

Investment calculation methods

Professor Tapio Ranta

BH61A0000
Content of the lecture

− Basics of investment accounting

− Initial values of the investment
− basic investment
− annual revenues and costs
− calculation interest rate
− investment holding period
− the residual value of the investment
− Markings used in investment calculations
− Investment calculation methods
− annuity method
− present value method
− internal interest rate method
− payback period method
− Return on investment
− Investment uncertainty
2
Breakdown of investments

− Investments are divided into tangible and intangible investments

− Material investments focus on buildings and equipment, for example
− Material investments are characterized by clear ownership relationships
and it is possible to buy and sell them
− In intangible investments, the opposite is true, i.e. ownership
relationships are difficult to determine and buying and selling them is
often impossible.
− Tangible investments are tied to only one purpose at a time, while
intangible investments can be utilized for many different purposes at the
same time. In addition, tangible investments wear out in use, which is
not the case with intangible investments
− Examples of intangible investments are research and product
development investments, investments in company brands, personnel
skills and organization.

3
 Breakdown of investments

− Investments can be further divided not only into tangible and intangible
investments as well financial investment and real investment, which will be
the focus of this lecture
− A financial investment is an investment in the securities of companies and
institutions
− The real investment, on the other hand, is an investment in real assets,
such as the purchase of machinery, equipment, land and buildings.

Money Money
Long lasting
Investor Company production
assets

Financial investment Real investment

Picture: Jyrkkiö & Riistama 2004 4

Breakdown of investments

− Unlike financial investments, real investments often have to wait before they can
generate a return.
− Real investments can also be divided according to their purpose into different
groups that are mandatory investments, replacement investments, rationalization
investments, expansion investments and rental equipment investments
− Mandatory investments are, as the name implies, obligatory, and are governed by
laws, regulations, and official ordinances. Mandatory investments include, for
example, occupational safety and environmental investments. The purpose of
environmental investments is to improve the state of the environment, for
example by preventing air or water pollution. They require little investment
calculations as they are mandatory and therefore only seek to be implemented as
economically as possible.
− Replacement or replacement investments are the replacement of worn, damaged
and old production equipment with new ones, for example, the replacement of an
old machine with a new one. Replacement investments therefore cover the
consumption of capital. The justification for making a replacement investment
may be, for example, a better economic benefit from the use of a new model.
Replacement investments do not require very extensive investment planning, as
they are often almost routine.
5
Breakdown of investments

− A kind of reinvestment is also rationalization investments, which are done to

improve production methods and labor productivity. The rationalization
investment replaces worn-out or obsolete real capital with a new type of
more efficient production method. It always aims to improve productivity by
saving on costs or increasing revenue
− Companies are also making investments to expand and increase capacity,
which are called expansion investmentsi. Examples of these are factory
expansion, construction of additional factories, or increase in the number of
production machines. An expansion investment can also be an investment
that enables the company to expand into a completely new industry, for
example as a result of an acquisition. In this case, the investments also
mean a strategic change in the company's business, and thus require
particularly careful investment planning.
− Rental equipment investments, which have their name referring to the
purchase of leased machinery and equipment. In them, the investment in
the actual machinery and equipment is made by the leasing company, and
the lessee of the machine thus has no risk.
6
Breakdown of investments

− Investments can also be divided according to their significance operational

and strategic investment.
− In general, income-financed operational investments are intended to
maintain the business and financial position in its current form. They are
often small changes and individual acquisitions such as small capacity
expansions, replacement investments and other maintenance investments.
Operational investments also include mandatory statutory investments,
which are generally related to environmental protection and occupational
safety of personnel.
− Strategic investments change the nature of a company's business, in most
cases in a completely new business area, which also increases risks.
− Strategic investments include all major expansions as well as new
businesses that enable the growth of a developing company.

7
Progress of investment planning

− Determining the need for investment

− Specifying objectives
− Finding investment alternatives
− Mapping of advantage factors of investment options
− Preparation and comparison of alternative calculations
− Investment capital requirement and financing planning
− Risk mapping
− Decision
− Investment implementation and control

8
Investment calculations

Investment calculations are needed in companies e.g. for the following

reasons:

− large sums of money are tied to long-term and uncertain projects

− the investments affect the company's profitability, growth, solvency and the
need for manpower
− the success / failure of investments affects the availability and price of
capital
− business management needs support to make an investment decision
− investment financiers need to be convinced of the viability of investment
projects.

9
Investment calculations

− The purpose of the calculation is to make a comparison between the different

options.
− The calculations are based on acquired or estimated data on:
− Markets
− Costs caused by the investment
− Returns from investment
− The need for capital

− Discretionary factors also affect the investment decision

− The company’s investment policy
− Company resources
− Ecological factors
− Ethical factors
− Legal factors
− Willingness to take risks
− Changes in the market situation

10
 Investment accounting

− An investment is a long-term expenditure that is expected to generate revenue

over several years. In investment calculations, the key issue from a computing
point of view is to make payments at different times comparable with each other.
− The investment calculation is a calculation extending over the life of the
investment, the aim of which is to determine the rationality and profitability of the
investment.
− the need is especially emphasized when there are several investment options
and they need to be prioritized
− making calculations also makes sense from a purely business point of view,
as the calculations have to consider implementation costs, receivables and
various financing options;
− The profitability of an investment should be assessed using at least two different
methods:
1. Annuity method
2. Present value method
3. Internal rate of return method
4. Payback period method
5. Return on investment
11
 Investment accounting

− Investment has a significant business role for companies, may determine

the future of the entire company
− Investment financing:
− the use of money and the source of money must be similar in nature, ie
a long-term project is limited by long-term funding;
− long-term financial instruments are equity, ie an increase in share
capital and a capital loan from owners or a long-term loan
− Indicative return requirements for investments:
JOSEK 2008
Importance Description of the investment Return requirement
Investments based on law or official regulations, such as No income requirement
occupational safety and environmental investments
Securing market position with investments
Renewal or basic repair of machines and equipment
Reducing costs through investment
Increasing returns on investment
Conquering new market areas or creating new products with risky
investments
− Often, the evaluation of investments is not just about looking at the return
value, an investment in another object lowers costs in another object 12
Investment accounting

− In large investments, the selection of the financing need is related to the

profitability review. An essential question in the analysis of financing is the
choice of different forms of financing, which part of the investment is
financed with income financing and different forms of support, and which
with capital financing, for example by taking out a loan.
− The chart below shows the financing options for the investment

Short-term
Debt capital
Equity financing Long-term

Own capital
Financial need

Income financing

Grants

Neilimo & New-Rauva 2007 13

Investment accounting

− The return requirement therefore means the minimum compensation set by

the company and the investors for the capital invested. In practice, the
return requirement is often related to the basis of the investment, ie what
the investment is based on and what it aims to achieve.
− The basic principle in setting return requirements is that the higher the risk
associated with the investment, the higher the return expectation must also
be:
− Companies use, for example, the average cost of capital, ie WACC
(Weighted-Average Costof Capital). WACC is the weighted average of
return on equity and debt requirements. It is a good idea to look at the
average instead of separate figures, because equity and debt investors
calculate a different return requirement for their investments because of
their different risk. The total share of equity and debt capital in the
company's total capital is generally used as a weighting factor. In doing so,
the return requirements of different types of capital affect the return
requirement of the entire capital in the same proportion as there are
different capitals in the company's total capital.

14
Investment accounting

− Making investment decisions is quite important for the company's

operations. A lot of money is invested in operations and revenues and costs
are expected to accrue over several years
− It is good to note that investments do not always seek to increase sales,
but, for example, rationalization investments usually aim to save costs.
− Often, similar repeated investments are rarely carried out in the same
company, in which case there is no previous experience for cost evaluation
− the investments aim to carry out the so-called turnkey delivery
− Despite the above-mentioned procedure, the costs tend to rise, e.g. due to
deficiencies discovered during implementation
− e.g. 20% extra may often be reserved in the budget
− An even worse risk than cost overruns is a delay in commissioning the
delivery

15
Investment accounting

− In an investment project, the design costs are about 10-15% of the total costs,
and at the design stage, however, almost all the remaining 85-90% of the costs
are committed.
− The basic idea of investment calculations is to compare different investment
options on the basis of their income and expenditure, and thus to rank these
different options according to their affordability.
− In order for an investment decision to be finally approved, its profitability should
be at least equal to the return on capital requirement.
− Without exception, financiers also require investment calculations to convince
them of the profitability of an investment project
− In addition, investment calculations make it possible to distance oneself from the
matters which are the subject of the decision and thus to examine them only in
the light of matters relating to profitability.
− It is a good idea to use a sufficiently long review period in investment
calculations. Indeed, it is often the same as the economic life of an investment,
such as a machine or equipment.

16
Investment accounting
Initial values of the investment
− There are always things involved in making an investment that cannot be
measured by any metrics or evaluated with numbers.
− However, it must always be remembered that an investment is not made
solely on the basis of discretionary factors, but that the economic role of the
investment must always be clarified.
− However, the following can be assessed by numbers:
− the total cost of the project, ie the basic investment, the acquisition cost
− annual income
− annual costs
− calculation interest rate
− the impact or holding period of the investment
− the residual value of the investment
− In determining the above variables, it is important to make use of the
company's previous experience in implementing investments and
profitability whenever possible.
17
 Investment accounting
Calculation methods
− In order to assess the profitability of the investment with the help of the above-
mentioned variables, several different investment calculation methods have been
developed, both mutually supportive and emphasizing different factors.
− Roughly speaking, all methods are based on a comparison of investment income and
expenditure, and when assessing profitability, it is practical to look at the issue
through the cash flows generated by the investment. Investment is often described
as simple payments to and from the cash register.
− The calculations can also take into account the time value of money, which is caused
by the timing of the cash flows mentioned above. The time value of money is typically
expressed by the interest rate, in other words by the calculation rate. The majority of
investment calculation methods are based on taking interest into account.
− Modern investment theory divides investment calculation methods into two parts;
advanced methods it recommends, as well as traditional methods. Present value
method (NetPresent Value Method, NPV) and the internal rate of return method
(Internal Rate of Return Method, IRR) are these so-called more advanced methods,
while traditional investment accounting methods include the payback period method.
Method) and investment rate of return (Return on Investment, ROI).

18
Initial values of the investment
1. Total cost of the project, ie basic
investment
− Acquisition cost refers to the initial investment, ie the capital and costs tied up at
the very beginning of the investment.
− Its amount can usually be determined more accurately and with less uncertainty
than the amounts of revenues and costs incurred in later periods.
− A typical investment is, for example, the purchase of a new production plant or a
new production machine (boiler investments, investment in flue gas cleaning,
etc.)
− Expenses included in the investment include e.g.
− land acquisition and commissioning
− machinery and equipment costs
− construction, transportation, installation and design costs
− interest expenses during construction
− deployment costs
− ancillary investments that usually arise
− additional need for working capital
− cost overrun provision
19
Initial values of the investment
1. Total cost of the project, ie
basic investment
− The basic acquisition cost can be divided into two main categories;
investment in fixed assets and working capital investment.
− Investments in fixed assets include all costs related to the investment,
which, depending on the investment, are, for example, the purchase price of
the machine with deliveries and installation work. The calculations must also
take into account the costs incurred for setting up the development work,
marketing and production process, as well as the costs incurred for
establishing a possible new organization and training the personnel.
− Working capital investment refers to capital tied to short-term production
factors. It consists of assets tied to inventories, prepayments, accounts
receivable and cash, from which non-interest-bearing debts such as
purchase and trade payables are deducted.
− The need for additional working capital is usually difficult to plan and most of
the time it is not possible to prepare for the need. However, in the case of
expansion investment, working capital is expected to increase.

20
Initial values of the investment
2. Continuous income and expenses
− It makes the most sense to deal with revenues and costs on an annual basis
together
− The return on energy investments is usually obtained over a long period of time
due to the long holding times of the investments
− Net investment income also affects profitability. If the net income generated by
the investment covers the basic investment, the investment can be described as
profitable
− The opportunity cost is the best possible return that will not be obtained if the
investment is not made
− Estimating returns is usually more difficult than estimating costs
− Sometimes an investment can only led to cost savings
− the reasonableness of the investment to be assessed and the return
requirement set for it
− an investment aimed at cost savings is called a rationalization investment
− In power plant investments, cost savings arise e.g.
− improved efficiency and thus reduced fuel consumption
− investment in an alternative cheaper fuel
− energy saving
21
Initial values of the investment
3. Interest rate
− The discount rate refers to the time value of money with which the investment's cash
flows are transferred from one point in time to another.
− The discount rate describes the price paid for money in connection with the basic
investment, i.e. interest
− interest reflects both the financing cost and the return expected from the
investment
− when financing an investment, the company has to pay costs that are based on
the interest rate. So it is a cost of capital. The cost of debt capital is determined
based on the reference interest rate, taking into account the risk premium
− investors' return requirement determines the cost of equity capital
− There is no interest-free money, so the investment must always be subject to at least
a general interest yield requirement for the loan.
− With the help of interest, the income and costs generated in different years can be
put on the same line as the current time of the investment
− taking interest into account in future income and expenses is called discounting
− In the calculations of this course, the calculation interest is always real, i.e. it does
not include changes in the value of money (inflation)
22
Initial values of the investment
3. Interest rate
Interest must be taken into account in investment calculations, regardless of
how the investment is financed. That is, also when only the company's own
income financing is used to finance the investment. This is because by
investing capital in a certain investment target, you give up the opportunity to
invest the same money elsewhere. The discount rate also includes the risk
associated with the investment. Generally, the return requirement set for an
investment through the calculation interest rate is higher, the greater the risk
associated with the investment. Roughly, the matter can be illustrated with the
help of the following picture:

Expectation of return

High risks

Low risks
23
Risk
Initial values of the investment
4. The effect period of the investment
− The useful life of an investment refers to the economic life of the investment
asset for the company
− Holding time may mean, for example, the physical life of a machine or boiler for
which the machine is usable for its original purpose.
− however, it is a good idea to start from the techno-economic service life, ie
the time when the new boiler / appliance makes the old use uneconomical;
− The technical and economic life is usually shorter than the physical life
− One option is to use taxpayer-approved depreciation periods as retention
periods, which are usually calculated from the residual value of the previous
year: JOSEK 2008
machinery and equipment 25% per year
7% per year for a shop, warehouse or factory building
4% per year for a residential and office building
20% per year from tanks and metal storage structures
20% of warehouse structures made of wood
20% per year from research buildings and structures
patents etc. rights, 10 years 244
Initial values of the investment
5. Residual value of the investment
object
− The residual value is usually set to zero in the investment calculation
− the holding period of the investment is long and, after the holding
period, discounted, the present value of the residual value is small
− it is also possible that the residual value is negative, eg if the investment
has become hazardous waste at the end of the retention period or it is
expensive to dismantle and remove
− over the long period, the effect of residual value on coverage is usually
small
− Residual values can be assumed, for example, in semi trucks and trucks,
excavators and various harvesting equipment.
− the magnitude of the residual value can be estimated by relating the
price of today's used machines

25
Investment accounting
Labels to be used
− i = calculation rate
− I = investment cost
− S = net annual return on investment
− n = holding period of the investment, a
− t = peak operating time, h
− c n,=i annuity factor
− a=n,ipresent value factor
− JA = residual value of the investment
− NA = present value
− (1 + i) = interest rate factor
1
−
(1  i) n = discount factor

26
Investment as a picture

initial investment

annual expenses

annual returns

net annual income

residual value
time

27
The time value of money
Over time, capital growth at interest rates
= prolongation 0Year Capital
100.00
Interest
10.00
1 110.00 11.00
2 121.00 12.10
3 133.10 13.31
4 146.41 14.64
5 161.05 16.11
6 177.16 17.72 Development of capital over time:
7 194.87 19.49
In 0, capital = 100
interest rate i = 10%
8 214.36 21.44
interest rate factor 1 + i = 1.10
9 235.79 23.58
10 259.37 25.94
11 285.31 28.53
12 313.84 31.38
13 345.23 34.52
14 379.75 37.97
15 417.72 41.77
16 459.50 45.95
17 505.45 50.54
18 555.99 55.60
19 611.59 61.16
20 672.75 67.27
28
The time value of money
Backward in time, discount rate and factor
Year Capital
0 14.86
Discounting is for interest 1 16.35
calculation 2 17.99

reverse event 3 19.78

4 21.76

Discounting is used to find 5 23.94

out how 6 26.33 Present value of future

7 payment:
It is much more valuable to 28.97
8 31.86 In 20, capital = 100
have a certain amount of interest rate i = 10%
9 35.05
money available today than discount factor
10 38.55
in the future. 1 / (1 + i) = 0.9091
11 42.41
12 46.65
The earlier the money is 13 51.32
received or paid, the more 14 56.45
valuable it is. This is mainly 15 62.09
due to two factors: 16 68.30
uncertainty about the future 17 75.13
and the ability to invest 18 82.64
money. 19 90.91
20 100.00
29
Time value of money: Making
alternatives comparable
− The decision maker has two options: € 1,000 in cash immediately or € 1,500
after five years. Which option does he choose if the calculated interest rate
is 10 percent?

− 1,500: (1 + 0.1) ^ 5 = 1,500: 1.61 = 931.38 euros.

− The decision maker should choose 1,000 euros in cash immediately. The
discounting used in the calculation is the inverse of the interest calculation.
If the decision-maker invests EUR 931.38 at 10% interest, he will receive
EUR 1,500 after five years.

30
 1. Annuity method

− In the annuity method, the basic investment is divided into equal annual costs over
the holding period, ie annuities
− the capital will be repaid within n years in equal annual installments
− the method is familiar, for example, from loan repayments
− The basic acquisition cost is divided by the annuity factor into equal items for the
different years of the holding period of the investment, the annuity factor:
n = number of years, holding period i = interest rate i(1  i) n
c n,i 
(1  i) n  1
− The investment is profitable if the annual net return is higher than the basic
acquisition cost annuity:
S = annual net return (constant) S  c n,i  I  0
I = investment cost
− Any residual value must be discounted to the present time and deducted from the
acquisition price to obtain the base acquisition price.

31
1. Annuity method
example
− If the acquisition cost of the investment is € 5,000, the holding period is 5
years and the interest rate is 7%, the annual costs of the loan are:

0,07  (1  0,07 ) 5
 5000 €  1219 €
(1  0,07 )  1
5

− An annuity is the product of the annuity factor and the underlying investment
− When using the annuity method, the amount of annual returns should be
approximately constant.
− The problem with the calculation method is that it is difficult to outline very
different years of net return.
− Books contain tables for the annuity factor, but the easiest way is to use
ready-made functions in spreadsheets and calculators
− If n increases towards infinity, then the annuity factor approaches i

32
Repayment of investment capital
Equal annuity, interest 10%
Year Investment, € Loan balance at the end of the Interest, Loan payment, € Interest + payment, €
year, € €
0 -100 -100 0 0 0
1 -98.25 10.0 1.75 11.75
2 -96.33 9.8 1.92 11.75
3 -94.22 9.6 2.11 11.75
4 -91.90 9.4 2.32 11.75
5 -89.34 9.2 2.56 11.75
6 -86.53 8.9 2.81 11.75
7 -83.44 8.7 3.09 11.75
8 -80.03 8.3 3.40 11.75
9 -76.29 8.0 3.74 11.75
10 -72.17 7.6 4.12 11.75
11 -67.65 7.2 4.53 11.75
12 -62.66 6.8 4.96 11.75
13 -57.18 6.3 5.48 11.75
14 -51.16 5.7 6.03 11.75
15 -44.53 5.1 6.63 11.75
16 -37.23 4.5 7.29 11.75
17 -29.21 3.7 8.02 11.75
18 -20.39 2.9 8.82 11.75
19 -10.68 2.0 9.71 11.75
20 0.00 1.1 10.68 11.75 33
In total: 135 € 100 € 235 €
Repayment of investment capital
Flat rate loan, interest 10%
Year Investment, € Loan balance at the end of the Interest, Loan payment, € Interest + payment, €
year, € €
0 -100 -100 0 0 0
1 -95 10.0 5 15
2 -90 9.5 5 14.5
3 -85 9.0 5 14.0
4 -80 8.5 5 13.5
5 -75 8.0 5 13.0
6 -70 7.5 5 12.5
7 -65 7.0 5 12.0
8 -60 6.5 5 11.5
9 -55 6.0 5 11.0
10 -50 5.5 5 10.5
11 -45 5.0 5 10.0
12 -40 4.5 5 9.5
13 -35 4.0 5 9.0
14 -30 3.5 5 8.5
15 -25 3.0 5 8.0
16 -20 2.5 5 7.5
17 -15 2.0 5 7.0
18 -10 1.5 5 6.5
19 -5 1.0 5 6.0
20 0 0.5 5 5.5
In total: 105 € 100 € 205 €
2. Present value method
(Net Present Value, NPV)
− When using the present value or discount method, income and expenses are
discounted to the current interest rate calculated
− The method is used in such a way that all future performances are multiplied by
the so-called with a discount factor to obtain performances corresponding to
present values
− When the calculation interest rate, ie the yield requirement, is increased, the
income stream must also increase in order for the investment to be profitable.
− An investment is profitable if the future net income is higher than the basic
investment
− The present value of K can be calculated as follows:
I = acquisition cost of the investment NA  I 
q1

q2
 ... 
qn

JA n
q = current annual payments on the investment (1  i)1 (1  i) 2 (1  i) n 1  i) n
JAn = residual value of the investment

− If the annual payments can be assumed to be equal, the present value is obtained
by multiplying the constant performance each year by the present value factor of
the periodic payments: an / i, whose values can be read
from the interest rate table (1  i) n  1

i(1  i) n 35
 2. Present value method

− In practice, the value of the net present value tells whether the future cash income
of the investment (i.e. the net income of the investment and possible residual
value) exceeds the resulting cash expenses (i.e. the acquisition cost of the
investment and other costs), when in addition the uncertainty factors related to the
investment and the time value of money are taken into account.
− The most profitable option when comparing different investment targets is the one
with the highest positive net present value.
1
− The coefficient may be referred to as the discount factor
i = interest rate, n = time (1  i) n

− The higher the value of the discounted interest rate, the higher the net cash flows
the company needs to keep the value of money at its current level compared to
the future.
− The present value method assumes that the net proceeds over the life of the
investment can be reinvested, giving them a return based on the effective interest
rate. The present value method allows for variations in annual returns and costs.

36
2. Present value method

− Investments of different sizes can be compared using a relative present

value (present value index). It relates the net present value to the
acquisition cost of the investment.
− The relative present value gets a value of one when the present value is
zero. Profitable investments are worth more than one. The higher the ratio,
the more profitable the investment.
− The relative present value is calculated using the formula (NPV +
Acquisition Cost) / Acquisition Cost.
− The net present value method has been criticized for its uncertainty in
forecasting cash flows and for ignoring its portfolio effect. Portfolio effect
refers to the effect of an investment on existing investments, such as their
returns.
− The weakness of the present value method is that large and small
investments are compared according to the amount of cash flow they
generate, and it does not take into account the amount of capital tied up in
the investment.

37
2. Present value method
example
− The performance of the investment is divided as follows: initial investment €
2,000, in years 1 - 4 € 1,000 / year and in year 5 € 500. 10% is used as the
calculation rate

(1  0,10) 4  1
− The present value of years 1 to 4 is: 1000  3169
0,10  (1  0,10) 4

1
− The present value of Year 5 performance is:  500  310
(1  0,10) 5

− The total present value is thus: -2 000 + 3 169 + 310 = 1 479> 0, ie the
investment is profitable
1,000 1,000 1,000 1,000
500
Income
Retention time in
1 2 3 4 5 years

2,000 38
2. Present value method
Example calculation
− The metal subcontracting company is planning an investment of EUR 50,000 to
improve its market position. The company has a good relationship with the main
supplier, which has indicated its desire to increase purchases of new products.
As it is a matter of expanding the market, the entrepreneur has set a return-on-
investment requirement of 10%. The return in this case is enough for him,
because the financing interest rate is low and it is possible to get an investment
TE Center assistance.
− Starting values
− purchase price 50,000 euros, delivery time only 3 months
− annual net income for the first two years is EUR 17,000, but thereafter,
according to the main supplier, demand for the final product changes so that
income falls to EUR 12,000 per year. We still have to be prepared for the
fact that deliveries will not continue for the fifth year.
− calculation interest rate 10%
− shelf life 4 years
− residual value EUR 10,000

39
 2. Present value method
example continued to previous page
Figure: cash flows during the holding period of the investment
returns residual value 10 000

holding period in years

acquisition cost EUR 50,000

Table: cash flow discounting

JOSEK 2008
TIME INVESTMENT RETURN DISCOUNT FACTOR NPV TOTAL

The investment is therefore profitable because the present values of net income are
greater than purchase price. As an alternative calculation, the interest rate at which
the investment would still be worthwhile or consider a lower residual value
40
than assumed.
3. Internal rate of return method
(Internal Rate of Return, IRR)
− The internal rate of return is the rate at which the discounted income and
expenses over a given period of investment are equal to
− The internal rate of return method is used to determine the interest rate at which
the present value of the investment is NPV = 0
− the present value of the net return on investment is therefore equal to the
basic acquisition cost
− The internal interest rate is solved with the same equations as the present
value, only the interest rate r in the equation is solved instead of the present
value
− the higher the internal rate of return, the more profitable the investment

(1  r) n  1
I q  0
r(1  r) n

− Exact mathematical determination of the internal interest rate is often relatively

difficult, so usually the interest rate is determined by experimentation and
interpolation.
41
3. Internal rate of return method

− The resulting internal rate of return (r) on the investment is compared with
the target interest rate (i). If the internal rate of return is higher than the
calculation interest rate (i.e., the return requirement), the investment is
profitable
− The internal rate of return indicator shows the percentage return on
investment for the capital invested in it as an annual interest rate. When
assessing profitability, it is compared with the calculation rate used by the
company, so that when the internal interest rate is higher than the
company’s return requirement, the investment is profitable. In addition, the
amount obtained can be easily compared with other key figures, such as the
cost of money or the corresponding internal interest rates for other
investments.
− The larger the interest rate differential (r - i) is, the more profitable the
investment
− When comparing several investments, the profitability order consists of the
interest rate differential r-i or the internal rate of return if the investment risk
and return requirement are at the same level

42
3. Internal rate of return method
Example calculation

− The basic acquisition cost is EUR 500,000, the annual net income is EUR
70,000 and the residual value is EUR 0. The holding time is 10 years. The
company's return requirement is considered to be 10 percent.

− The acquisition cost is divided by the annual net income: EUR 500 000:
EUR 70 000 = 7,143. From the interest table for the discount factor for
subsequent periodic payments, the interest rate for 10 years is obtained,
which corresponds to a calculation result of 7.143.

− The internal interest rate is between 6 and 7%. The investment is

unprofitable.

43
 4. Payback period method
(Payback period)
− The payback period of an investment indicates in years the period during which the
investment repays itself, ie the amount committed to the investment is released
from the investment
− at its simplest, it is obtained by dividing the acquisition cost of the investment by
the available annual income, in which case interest is not taken into account;
− If the interest is taken into account and the annual income is assumed to be
constant, the repayment period n can be calculated as follows:
I = acquisition cost of the investment
q = annual income n
 
- ln 1i  qI  ln(i)
i = the calculation rate 
ln 1  i
− The weakness of the payback period method is that it does not take into account
what happens after the payback period
− however, it is useful when evaluating the liquidity (liquidity) and uncertainty of
an investment
44
4. Payback period method

− The method is widely used for its computational ease

− According to the method, it is advantageous to make investments that
return the invested money as quickly as possible
− The method does not show the profitability of the investment, but the
financial impact. Therefore, it should never be used as the only valuation
method, but should be accompanied by methods that show the return on
investment, ie the interest rate.
− The payback period method often favors short-term projects over long-term
projects, even if they are profitable.
− In a tight economy, the financial impact can be the most important factor in
making an investment decision. The sooner it pays for itself, the better the
investment

45
4. Payback period method
Example calculation
− If the acquisition cost of the investment is € 9,000 and it generates an annual
income of € 1,200, the calculation interest rate is 7%

- ln 0,07
1
 1200
9000
  ln(0,07)
n  11vuotta
years
ln 1  0,07 
− Interest-free repayment period:

9000
n  7,5vuotta
years
1200

46
4. Payback period method
Example calculation

− The basic acquisition cost is EUR 500,000, the annual net income is EUR
70,000 and the residual value is EUR 0. Holding time is 10 years.
− The repayment period is EUR 500,000: EUR 70,000 = 7.14 years. The
investment is profitable.

47
5. Return on investment
(Return is Investment, ROI)
− The return on capital method divides the average net return on an
investment by its average tied-up capital, in which case the return on capital
can be calculated as a key figure for the investment. It interprets the
relationship between the return on an investment and the capital invested in
the investment.
− The net annual return is obtained by deducting depreciation from the
average return, which is calculated as the quotient of the difference
between the acquisition cost and the residual value of the investment and
the holding period of the investment.
− The average capital tied up in an investment, in turn, is obtained by dividing
the sum of the acquisition cost and the residual value of the initial
investment by two.
− When calculating profitability, the calculated rate of return on capital is
compared with the target rate of return on capital. If the calculated rate of
return exceeds the target value, it is profitable to make the investment.

48
5. Return on investment

− However, the return on capital method has similar weaknesses as the

payback period method, ie it does not take into account the time value of
money.
− Defining the criterion of profitability is also mentioned as a problem. It is
difficult to find a suitable comparison base for the return percentage. The
generally used cost of financing an investment is not necessarily suitable as
a basis for comparison to determine a profitable investment from an
unprofitable one.

49
5. Return on investment
Example calculation
− The following starting situation is used in the example:
− the acquisition cost of the investment is € 50,000
− the residual value of the investment object is € 5,000
− investment period 8 years
− annual return € 9,000
− The annual depreciation is (€ 50,000 - € 5,000) / holding period 8 years = €
5,625
− Annual net income after depreciation:
annual return - depreciation, ie € 9,000 - € 5,625 = € 3,375
− The average amount of capital tied up in investment is:
acquisition cost + residual value / 2, ie (€ 50,000 + € 5,000) / 2 = € 27,500
− The average return is therefore:
(100 x annual net return after depreciation) / average capital
= (100 x 3375 €) / 27500 €
= 13%

50
5. Return on investment
Example calculation
− The basic acquisition cost is EUR 500,000, the annual net income is EUR
70,000 and the residual value is EUR 0. The holding time is 10 years.
− The depreciation method is straight-line depreciation. The capital employed
is assumed to change linearly.
− The average capital employed is (EUR 500 000 + EUR 0): 2
= EUR 250 000.
− The annual straight-line depreciation is 50,000 euros.
− Net income after depreciation is EUR 70,000 - EUR 50,000 = EUR 20,000.
− The average rate of return on capital is 100 x (20,000: 250,000) = 8%. If the
company’s return requirement is considered to be 10 percent, the
investment is unprofitable.

51
5. Return on investment
(DuPont chart)

Sales
minus Net profit
Margin
Variable minus
Profit
costs
Fixed
Profit-%
costs
Sales

Return on
times investment %
ROI
Financial Sales
Current assets
Capital
assets turnover
rate
Trading Total
assets investment

Fixed Tied equity

Fixed
assets
assets
52
Investment accounting methods
Summary
− In a practical calculation situation, several methods are applied
simultaneously, after which the decision is made on the basis of the
combined effect of different calculation results.
− Decision-making also involves personal judgment and non-financial criteria.
− About the investment calculations The most used methods are the internal
interest rate, the payback period and the return on equity (ROI) method.
− The profitability of the investment should be considered separately before
taxes and after taxes.
− Inflation is taken into account in the calculations either nominally or in real
terms.
− In the follow-up of the investment, answers to the following questions are
sought: Were there any unexpected costs? Was the investment worthwhile?
Where did the basic assumptions of the calculations fail? Did external
conditions change? What reasons explain the errors? The monitoring results
affect the planning and implementation of new investments as a result of the
functionality of the quality system.
53
Investment accounting methods
Summary
− The table below summarizes the decision-making rules for the different
investment accounting methods.

Net present value (NPV) The higher the better

Internal rate of return (IRR) The higher the better
Payback time The shorter the better
Monthly annuity The lower compared to net return,
the better
Return on equity (ROI) The bigger compared to the profit
target, the better

− According to investment accounting theory, a major factor affecting the usability

of the accounting method is the time value of money. The more advanced
methods internal interest rate and net present value take the time value of
money into account, while the thumb adjustment methods payback period and
return on capital method do not. 54
Investment accounting methods
Summary: example calculation
− The example estimates four investments that cost 1,000 euros each. The
investments generate cash flow for five years and are then worthless.
Estimated net cash flows are shown in the table. At the bottom of the table,
investment options have been assessed using four methods. The option
selected based on each method is in bold.
Year

Internal rate of return

Net present value
Return on investment

Payback
time
55
 Investment accounting methods
Summary: example calculation
− The investment calculation methods presented above differ slightly, with the
consequence that their results on the profitability of the investment may sometimes
be inconsistent.
− For example, the present value method and the internal rate of return method
take into account the time value of money, while the payback time and rate of
return methods do not take into account.
− The present value method is often considered to be the correct, justified and
theoretically recommended investment calculation method in both investment and
financial theory.
− Its assessment of the profitability of the investment, i.e. the return on
investment and its reinvestment at a cost of capital, is quite realistic.
− It gives a clear picture of interest and other payments for the entire life of the
project.
− When using the present value method, the most problematic is to determine
the interest rate to be used in discounting. This must be chosen carefully
because the interest rate used reflects the return requirement for the
investment. 56
 Investment accounting methods
Summary: example calculation
− The advantage of the internal rate of return method is its easy-to-understand and
comparable percentage value.
− In addition, as the name implies, it only takes into account aspects related to the
investment internally and its value is derived from the project's own cash flows, so
changes in market interest rates, for example, do not affect its calculation.
− On the other hand, the problem with the internal rate of return method is that it
assumes that the money released from the investment yields as well as the
investment itself. Such an assumption is not always realistic.
− The advantage of the payback period method is its clarity and ease, which is why
it is often considered to be the most commonly used investment calculation
method in practice.
− Indeed, it is widely used as a qualifying method for the first phase of investment
projects before a broader analysis.
− Often used alongside other, more advanced methods. The payback period quickly
gives an overview of the profitability and realism of the investment project.
− Its weaknesses include the fact that it does not take into account the time value of
money, the interest rate, or net income after the repayment period. For this
reason, especially when comparing different long-term and short-term productive
investments, the use of the payback period method can easily lead to erroneous
conclusions.

57
 Investment accounting methods
Summary: example calculation
− Regarding the advantages and disadvantages of the annuity method, it can be
stated that in a situation where the return-on-investment expectations are not
uniform, the application and interpretation of the annuity method is difficult.
− However, it can be considered an advantage that the annuity method takes into
account the effect of the time value of money in the calculations.
− The disadvantage is again related to the calculation of the annuity method,
which is very difficult to calculate manually without an annuity factor table or
with the help of programs developed specifically for this purpose.
− The benefits of return on capital (ROI) can be considered its basic form is easy and
clear to calculate.
− On the other hand, there is a clear weakness in the rate of return on capital in
that it does not take into account the time value of money at all as a method.
− In addition, a clear weakness of this method is that both the numerator and the
denominator of the formula can be calculated in many different ways, giving
different results. Therefore, the method of calculating the rate of return on
capital involves considerable room for interpretation, depending on the figures
used in the calculations.

58
Taking uncertainty into account in
investment accounting
− There is always a lot of uncertainty involved in investment calculations, as
the calculation is based on information that is only an estimate of future
events.
− uncertainty increases as the term of the investment lengthens
− A company’s investment policy determines how the risk posed by
uncertainty is addressed
− a prudent investment policy maker may, for example, estimate lower
return on investment and higher costs and calculation interest;
− Risk and sensitivity analysis
− the risk analysis seeks to measure the uncertainty associated with the
profitability of the investment
− the sensitivity analysis can examine the effect of errors in the
assessment of the profitability factors of the investment on profitability;
− eg annual income, calculation interest, etc.
− after each change, the impact on the return on investment is
examined

59
Taking uncertainty into account in
investment accounting
− The main principle in investment-related risks is that the higher the
expected return on investment, the higher the risk and uncertainty
associated with it.
− As investments are forward-looking, the basic problem and uncertainty in
investment calculations is the realization of income and expenditure items at
different times.
− The longer you have to wait for money, the greater the uncertainty about
getting it. The value of money also decreases as we go into the future,
when we talk about the time value of money.
− There is also a risk associated with the investment due to a measurement
problem. Investment decisions must take into account not only measurable
factors but also so-called discretionary factors.
− In order to take into account the uncertainty and risk associated with
investment calculations, various risk assessment methods have been
developed, the most common of which is sensitivity analysis.

60
Sensitivity analyzes

− Since there is always some degree of uncertainty in the initial values, the
sensitivity of the final result to these changes can be calculated by varying the
initial values.
− The most important thing is to study and find the most unfavorable assessment
errors, after finding which the profitability of the investment can be most critically
assessed
− When performing a sensitivity analysis for each factor affecting profitability, the
factors whose assessment errors have the strongest impact on the profitability of
the investment in question are identified.
− The sensitivity analysis can vary:
− The size of the investment
− Residual value
− Calculation rate
− The rate of increase in the cost level
− Annual cost
− Annual income
− Plant life
− As well as other possible output quantities

61
Sensitivity analyzes

− The effect of different

variables on the total
investment
profitability (IRR)
− All calculation factors are
changed by the same
percentage, for example 10%,
20% and 30%, regardless of
how likely the change is for
this particular factor

Investments
Selling price
Materials, supplies and goods 62
Other fixed costs
Sensitivity analyzes

− There are two applications of sensitivity analysis. In the three-valued

calculation, the most accurate profitability estimate is first determined. After
that, an optimistic and a pessimistic value is determined for each profitability
factor, with the help of which new profitability estimates are calculated by
changing one factor at a time. The number of profitability values obtained as
a final result increases the more variables there are in the calculation. With
the help of profitability estimates, it is possible to determine the range of
profitability and the frequency of occurrence of different profitability values.
− The method of critical values is another application of sensitivity analysis. It
calculates for each profitability factor the value at which the investment
becomes exactly profitable. The result shows how much each variable can
withstand an unfavorable deviation before the investment becomes
unprofitable.

Puolamäki & Ruusunen 2009 63

Summary
− Challenging in investment calculations:
− taking into account uncertainties
− reliable determination of input data
− measuring revenue / costs
− impact assessment / evaluation / measurement
− comparability of performance at different times
− interest rate fluctuations, the effect of inflation
− The methods of repayment period and internal rate of return are the most widely used. The
internal rate of return method emphasizes the profitability of the investment, and the
payback period method has financial implications. Therefore, they complement each other.
− The profitability of the investment is affected by both measurable and discretionary factors
(eg the impact of the increase in capacity on security of supply or improved product quality,
improved company customer service and improved product functionality.)
− Only measurable factors can be included in the calculation methods underlying decision-
making, although discretionary factors often play a significant role in decision-making.
− However, the most important thing about the investments made by a company is always
that the strategy thought by the company's management guides the investment decisions
and not the investments the strategy of the company's management.

64
Summary

− Small companies seem to prefer payback periods as well as rates of return

on capital, while large companies rely on present value and internal rate
methods.
− The difference here in the use of so-called more advanced methods may be
explained by the potentially most comprehensive resources and broader
financial management expertise of large companies.
− The payback period fascinates companies because of its simplicity, as it
allows them to quickly, for example, even before a more detailed analysis,
cut unprofitable alternatives. In addition, it emphasizes cash flows closer to
the present, which are, of course, more certain than cash flows well into the
future.
− Preference for the internal interest rate can be based on its already stated
easy comprehensibility and comparability between different investments
due to its percentage form rather than the net present value, which gives an
absolute number as a result of the calculation.

65
Thank you for your interest!
Welcome to the exercises!