Profitability Investment Criteria

Profitability Investment Criteria – Investment analysis is the process of evaluating each attribute of an investment. Investment appraisal involves evaluating the properties of an investment. Return, risk, liquidity, tax benefits and convenience are important attributes to consider before investing in any particular type of investment. This investment evaluation is for deciding or selecting suitable investments.

Investment is an integral part of any business. All companies have multiple forms of investment, be it a project or an asset. Investment returns directly affect the profitability of the company. One of the main responsibilities of the financial manager is to use company funds effectively to optimize profits.

Profitability Investment Criteria

Funds are used for short-term or long-term investments, depending on the availability or inactivity of the funds. To explain further, sometimes companies are concerned with scaling. Hence, looking for capital acquisition and investment in profitable projects. It uses passive money to invest in other assets or other companies through equity-like means. Instead, in a sometimes seasonal business, excess working capital is invested in short-term investment options, primarily money market instruments.

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Basically, investment options need to be analyzed or evaluated in order to make effective investments. The following investment attributes should be considered when evaluating an investment.

A reasonable return on investment is the first condition for effective investment. The rate of return is the ratio of the annualized earnings and price appreciation to the purchase price of an asset or investment.

Let us illustrate it with an example. Suppose someone invests Rs.100 in the equity of Company A. 100. During the year, Company A paid a dividend to its shareholders of Rs. 10 and year-end share price Rs. 115.

For deeper analysis, the rate of return can be broken down into two parts: current rate of return and capital gain/loss. In the current example,

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Here, the current yield is 10% and the capital gain is 15%. Current income is more stable than capital gain. Capital appreciation may not always exist. In a bad market, capital loss is very likely.

Rates of return for different investment options vary widely. Remember the famous saying, “The higher the risk, the higher the reward.” Expecting higher returns on high-risk investments is a common phenomenon. Risk means uncertainty of return. In statistics, risk is evaluated based on variance, standard deviation, and beta parameters. The more a security deviates from its intended effect, the higher the risk is considered. The challenge for a financial manager when investing money is to minimize risk while achieving high return on investment.

Liquidity refers to the marketability of an investment. For example, a share in a large company can be easily liquidated in the stock market. On the other hand, money invested in assets (machinery) is not as easily liquidated as equity. An investment is considered highly marketable or liquid. It can be easily traded with low transaction costs and low price changes. When funds are available in the short term, financial managers look for more liquid investments. Liquidity is always preferred as it helps managers maintain flexibility.

This works for some investments, but not all. In addition to tax-exempt countries, most countries have tax exemptions for certain investments. Therefore, this is an important consideration for tax-advantaged investments, as a major portion of their costs are taxes.

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Convenience means easy investment. We consider an investment to be convenient when it can be easily made and managed. For example, investing in equity is easier than real estate because it involves a lot of documentation and legal requirements.

Therefore, investment attribute analysis viz. Return, risk, liquidity, tax benefits and convenience answer the key question – which investment option to choose?

One of the main tasks of financial managers is investment analysis and evaluation. It assesses the physical and financial feasibility of new investment opportunities. The most important thing is financial survival because the first goal of any company should be financial survival to achieve any other goal.

Investment analysis and evaluation is a step-by-step decision-making process to assist managers in deciding whether to accept or reject a project. Basically, it assesses the financial feasibility of a project by analyzing its cash flow and other factors. Let us follow the step by step process mentioned below:

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After coming in contact with an investment project, the first thing the manager should do is calculate the project’s cash flows. Like the foundation of a building, it must be very strong. Estimates of cash flows must be as accurate as possible because they are the basis for all subsequent steps in the process.

For example, assume a project with an initial investment of $30,000 would have the following cash flows.

The next important thing is to find the right opportunity cost of capital. Why find the opportunity cost of capital? As current investment returns are compared with the returns of the next best alternative investment opportunity.

The opportunity cost of capital is the rate of return the investor would have earned if he had not made the investment. This assessment is just as important as calculating cash flow. In order to maximize the investors’ wealth, it is crucial to choose projects that have better returns than what they are currently earning. We are now in a race to find the right returns for investors.

Net Present Value And Other Investment Criteria

Continuing with the same example, assume investors are the general public. If the money is distributed to them as dividends, they will invest in term deposits at an interest rate of 12% per annum. Therefore, this interest rate becomes the investor’s opportunity cost.

There is no need to conduct market research at this stage. This step uses the opportunity cost of capital and discounts the cash flows calculated in step 1.

In this step, we sum all the discounted cash flows to find the present value of all future cash flows. The present value in our example would become $45,279.

Knowing the present value of the future cash flows, we can compare them to the current investment we need to make, say $40,000. The present value of all estimated cash flows is $5,279 higher. This means the project is worth doing.

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Put another way, we can conclude that paying $40,000 would result in $45,279. The $5,279 is a reward for all the hard work done by the organization for the successful implementation and execution of the project throughout the life of the project.

We used the investment analysis tool of net present value, but other tools and techniques exist, such as internal rate of return, profitability index, etc. We believe that NPV is the best method of investment analysis compared to all other methods. “Why is NPV the best measure of investment valuation?” See our article on

Sanjay Borad is passionate about making things simple and easy. This blog has been running since 2009 and tries to explain “financial management concepts in layman’s terms”. Return on investment (ROI) is a performance measure used to evaluate the efficiency or profitability of an investment or to compare the efficiency of different investments. ROI attempts to directly measure the rate of return on a particular investment relative to the cost of the investment.

To calculate ROI, the return on investment (or return) is divided by the cost of the investment. Results are expressed as percentages or ratios.

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ROI = Current Valueof Investment – CostofInvestment CostofInvestment begin &text = dfrac-text}}\ end ROI = CostofInvestment Current Valueof Investment – CostofInvestment

“Present value of an investment” refers to the income received when the interest-bearing investment is sold. Because ROI is calculated as a percentage, it can be easily compared to the returns on other investments, allowing different types of investments to be measured against each other.

ROI is a popular metric due to its versatility and simplicity. Basically, ROI can be used as a basic measure of the profitability of an investment. It could be the ROI of a stock investment, the ROI of a company’s anticipated expansion of a factory, or the ROI resulting from a real estate transaction.

The calculation itself is not very complicated, and due to its wide application, it is relatively easy to explain. If an investment has a net positive ROI, it’s probably worth it. But these signals can help investors avoid or choose a better option if there are other opportunities with higher ROI. Similarly, investors should avoid negative ROI, i.e. net loss.

Profitability Index Method

For example, invest $1,000 in Joe Slice Pizza Corporation in 2017 and sell those shares a year later for a total of $1,200. arriving

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