Dynamic investment appraisal methods

Although static investment appraisal methods are suitable for an initial rough assessment, they exhibit conceptual weaknesses, and therefore dynamic methods should be employed for the detailed examination of investment decisions. Notably, the factor of time is neglected within static methods, leading to profits being treated equally regardless of when they occur. This failure to consider the compounding effect of interest becomes more pronounced the longer the project's duration, and thus the greater the deficiency in static investment appraisal methods. Another common error in static investment appraisal is that only the year of acquisition (i.e., the investment) is analysed, and the assumptions made for the first year are intended to apply for the rest of the useful life, even though wages, revenues, energy prices, etc., are subject to fluctuations over time.

Dynamic investment appraisal methods require more input data, but offer greater accuracy. The advantages of dynamic investment appraisal methods lie primarily in the consideration of the timing of cash inflows and outflows (the earlier the return, the higher the value) and in better comparability with alternative investment opportunities. Simply put, dynamic methods take into account the time difference between payments and receipts and make cash flows comparable by either compounding to the future value (future value method) or discounting to the investment date (net present value method).

The following describes the common dynamic investment calculation methods and illustrates possible interpretations for the calculated results. These are the net present value method, the dynamic annuity method, the internal rate of return method, and the dynamic payback period calculation.

In order for dynamic procedures to be sufficiently representative, several assumptions must be met. In addition to the existence of a perfect and complete capital market, it is assumed, for example, that capital is available without restriction and is available for the underlying investment projects. Furthermore, it is assumed that the discount rate corresponds to the interest rate at which money could be invested on the capital market – the decision therefore lies in investing the capital on the capital market or in the project being examined. Finally, the discount rate must be increased by a risk premium if necessary – this is necessary if security, or the same security, cannot be assumed for all projects.

Net present value method

The net present value (NPV) of an investment is the sum of all incoming and outgoing payments, discounted to the point in time of the investment (t0). It is important to allocate the investment's incoming and outgoing payments to the planning period, which typically spans 5 to 10 years. The NPV shows by how much the investment "generates more" than an alternative investment at the discount rate. Using the NPV method, both absolute and relative profitability can be calculated. The NPV is heavily dependent on the discount rate: the higher the interest rate, the less advantageous the investment is, as the present value of future payments becomes lower due to the higher interest rate. The NPV method also allows for the consideration of complex parameters such as tax effects and financing decisions. Since capital costs are already reflected in the discount rate, interest expenses or interest payments (i.e., imputed interest) must not be considered again in the cash flow when calculating the NPV.

Dynamic Annuity Method

The annuity of an investment is the annual rent amount over the project's useful life, where the present value of the rents equals the net present value. The dynamic annuity method is based on the same principles as the net present value method. However, it allows for a better comparison of investments with different useful lives, as the net present value method reaches its limits here. The annuity, as a constant payment over a defined period, represents the maximum amount that can be withdrawn, so that the net present value of the remaining payments is zero. Therefore, the (dynamic) annuity method can be used to determine the amount that can be withdrawn from a project's returns over its lifetime, such that the net present value is exactly zero (the return is then achieved based on the discount rate).

Internal interest rate

The internal rate of return, or the internal rate of return method as a form of dynamic investment appraisal, operates on the premise that projects should only be undertaken if their internal rate of return meets or exceeds the required minimum rate of return. The internal rate of return is the interest rate at which the net present value of an investment is zero. In this regard, cash inflows and outflows must also be estimated over time. In other words, when using the internal rate of return method, a scarcity of capital is fundamentally assumed. Consequently, a positive net present value is not the deciding factor, but rather the rate of return on the capital required for the investment. Conversely, it shows the maximum level that capital costs can reach without the net present value becoming negative.

A key premise and simultaneous weakness of the internal rate of return (IRR) method is that all payments are discounted at the IRR. This assumes that all project payments can be invested or procured at the IRR. If the IRR is greater than the discount rate, it is assumed that payments resulting from the investment project can be reinvested on the capital markets under better conditions (the "reinvestment premise"). The "modified internal rate of return" (MIRR) attempts to rectify this deficiency. Specifically, within the framework of the MIRR method, a second discount rate is used for the reinvestment of returns. As all returns are now invested at a uniformly specified interest rate, all returns are treated identically in calculations. Typically, the marginal cost of capital is used as the interest rate for intermediate reinvestment.

Dynamic Amortisation Calculation

When using dynamic payback period calculation, the investment with the relatively shortest payback period is selected. The dynamic payback period is a key figure for risk assessment and explicitly considers interest and compound interest – it is similar to the static payback period (however, within the framework of the static payback period, average returns are assumed and the time factor is not taken into account accordingly). Specifically, this investment appraisal method can be used to determine the period within which the investment outlay is recouped in the form of cash. Each period is considered individually, and the returns are discounted to time t0 in order to account for the different timings of the payments.

The use of investment appraisal methods – both static and dynamic – can enhance the quality of (investment) decisions, not least by requiring thorough consideration of the investment and a quantitative assessment of relevant aspects. It should be noted that the use of investment appraisal methods may require an extensive data base, such as the most accurate possible assumptions about future inflows and outflows, tax effects, and financing decisions, etc.

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