Changes

Several economic parameters can be used to measure investment efficiency. When capital is limited, these yardsticks permit projects to be ranked from high to low until the available capital is exhausted. The investment efficiency ratios are indicators of the projects profit per dollar of investment. The two parameters presented here are very similar but do differ slightly. Primarily, they differ in our perception of how the budgeting process actually takes place. Regardless of the economic yardstick used, you must be consistent and compare all projects with the same yardstick. The first ratio is called the ''investment efficiency''<ref name=pt02r3 /> and is defined as

Several economic parameters can be used to measure investment efficiency. When capital is limited, these yardsticks permit projects to be ranked from high to low until the available capital is exhausted. The investment efficiency ratios are indicators of the projects profit per dollar of investment. The two parameters presented here are very similar but do differ slightly. Primarily, they differ in our perception of how the budgeting process actually takes place. Regardless of the economic yardstick used, you must be consistent and compare all projects with the same yardstick. The first ratio is called the ''investment efficiency''<ref name=pt02r3 /> and is defined as

:<math> \mbox{Investment efficiency}\nonumber</math>

:<math> \mbox{Investment efficiency}</math>

:<math>&\quad {=}\, \frac{\mbox{Cumulative net present value}}{\mbox{PV of maximum negative cash flow}}\nonumber\\&\label{978-1-62981-110-9_22_eq12(1)}</math>

:<math>&\quad {=}\, \frac{\mbox{Cumulative net present value}}{\mbox{PV of maximum negative cash flow}}</math>

The second parameter is called the ''discounted profit to investment ratio'' and is defined as follows:

The second parameter is called the ''discounted profit to investment ratio'' and is defined as follows:

:<math> \mbox{Discounted profit to investment ratio}\nonumber</math>

:<math> \mbox{Discounted profit to investment ratio}</math>

:<math>&\quad {=}\, \frac{\mbox{Cumulative net present value}}{\mbox{PV of all investments}}\nonumber\\&\label{978-1-62981-110-9_22_eq13(2)}</math>

:<math>&\quad {=}\, \frac{\mbox{Cumulative net present value}}{\mbox{PV of all investments}}</math>

Note that the numerator is the same for both yardsticks. However, the investment efficiency parameter uses only the present value of the early negative NCFs in the denominator. The present value of the MNCF is defined in this case as the greatest cumulative discounted out-of-pocket expense. The discounted profit to investment ratio keeps all investments separate and uses the cumulative present value of each investment as the denominator. The significance of this difference has not been rigorously tested to our knowledge. It is believed, however, that the investment efficiency can be best applied when the investor believes that the project itself finances some or all of future project investments, in contrast to the case when it is felt that all future investments must go through the budgeting process and compete with other projects for investment capital. In the case of smaller projects that generate cash rapidly, the investment efficiency parameter may be the best one. In cases where major capital expenditures occur over several years, however, the profit to investment ratio may be more representative of the actual process. Regardless of which parameter you use, be consistent!

Note that the numerator is the same for both yardsticks. However, the investment efficiency parameter uses only the present value of the early negative NCFs in the denominator. The present value of the MNCF is defined in this case as the greatest cumulative discounted out-of-pocket expense. The discounted profit to investment ratio keeps all investments separate and uses the cumulative present value of each investment as the denominator. The significance of this difference has not been rigorously tested to our knowledge. It is believed, however, that the investment efficiency can be best applied when the investor believes that the project itself finances some or all of future project investments, in contrast to the case when it is felt that all future investments must go through the budgeting process and compete with other projects for investment capital. In the case of smaller projects that generate cash rapidly, the investment efficiency parameter may be the best one. In cases where major capital expenditures occur over several years, however, the profit to investment ratio may be more representative of the actual process. Regardless of which parameter you use, be consistent!