Assessment of investment projects on the basis of production efficiency

Transcription

1 MPRA Munich Personal RePEc Archive Assessmen of invesmen projecs on he basis of producion efficiency Vadim Daskovskiy and Vladimir Kiselyov Naional Insiue of Economics (NIEc) May 2010 Online a hps://mpra.ub.uni-muenchen.de/41111/ MPRA Paper No , posed 7 Sepember :09 UTC

2 Assessmen of invesmen projecs on he basis of producion efficiency by Vadim Borisovich Daskovskiy, Naional Insiue of Economics (NIEc), Moscow, Russia, and Vladimir Borisovich Kiselyov, Moscow, Russia, Absrac Mehodologically, he recommended invesmen projec (IP) selecion sysem is disinguished from one in force by: new concepion allowing for ime facor; evaluaing IP efficiency by evenual reproducion resuls, no by inermediae invesmen aciviy resuls (included is a generalized producion efficiency indicaor); separaion of condiions / indicaors adequae for a marke economy in ransiion and an advanced (sable) one; allowing for differences beween enerprises (enrepreneurs ) and invesors economic ineress. The make-up of assessmen sandards was exended by asks o be solved. An enerprise s highly compeiive posiion afer IP realizaion when he bes analogue sales profiabiliy is achieved was aken as he invesmen success crierion. May 2010 Keywords: invesmen efficiency; invesmen projec; profi; he discoun rae; projecion period; invesmen phase; operaion phase; ne presen value (NPV); discouning cash flow (DCF); Ne Profi in Time (NPT); Profiabiliy Index in Time (PIT) JEL Classificaion: G31, G32, G11, O16, O22, D61, D81, E22, M21 1

3 Imporan Issue. The curren economic challenges, including he globalizaion of compeiion, growh of mineral exracion coss driven by deerioraing geological and mining condiions and depleion concerns (for hydrocarbons), he aging of populaion in developed naions, growing negaive environmenal impac of indusrial aciviy due o increased consumpion and conaminaion of naural resources, can be addressed primarily wih more efficien use of resources (raw maerials, fuels, elecric power, and labor) achievable via inensive developmen of science, science-inensive echnologies and heir produc innovaions. However, he previous half a cenury of experience accumulaed by developed counries demonsraes ha innovaive reforms of producion and echnologies aimed a more efficien use of resources and humanizaion of labor involve he shif of focus from coninuous inellecual and physical effors of workers owards increasingly complicaed producion processes and sricer process parameers in order o manufacure high qualiy producs wih new characerisics. This rend leads o more expensive equipmen and process conrol and managemen sysems. Invesmen projecs become more capial-inensive, capial invesmens ino greenfield projecs and producion upgrades grow per uni. These developmens have become a global rend, which collides wih he fundamenal provisions of generally acceped invesmen assessmen mehodology focused on prevening he increase in capial coss of invesmen projecs (IP) and complicaing he analysis of benefis from scienific and echnological innovaions. This siuaion calls for immediae soluion of mehodological issues relaed o an innovaive upgrade of physical infrasrucure. In invesmen aciviy, he success of implemening a profiable invesmen projec depends srongly on he efficiency of he projec selecion sysem and he adapaion hereof o he exising and evolving economic condiions. Decisions made on he basis of invesmen assessmen mehods have an impac boh on corporae and naional ineress, since he complex of privae decisions ulimaely shapes he characer and parameers of a naion s producion resources. Inroducion of innovaions ino all areas of business and plan upgrades press for improved scienific suppor of efficiency analysis of invesmens. Based on our analysis of works on he above issue by numerous auhors (in paricular, books by Behrens and Hawranek 1995; Brigham and Ehrhard 2009; Norhco 1997), we have idenified he mos common invesmen efficiency merics applied o evaluae and selec invesmen projecs for implemenaion (Table 1). The sysem of invesmen efficiency merics can be classified ino wo groups: discouned (NPV, PI, and IRR) and unsophisicaed (ROI and payback period). Discouned merics are considered more imporan, since heir projecion horizon covers he oal life of an invesmen projec and allows for analyzing all possible changes in business parameers over he projec life and adjusing hem for he effec of ime. The adopion of he new (phased) approach o esimaing value in ime as a basis of economic analysis of invesmen projecs implies he liquidaion of discouned merics, as a group, and he consrucion of replacemen (alernaive) efficiency indicaors based on he new approach 1. The effec of ime is associaed wih anoher invesmen valuaion issue: he economic uncerainy ypical of emerging markes (Russia, Kazakhsan, ec.), as well as underdeveloped and developing economies, and he resuling inaccuracy of forecasing invesmen projec cash flows for a 5, 10, or 15 year horizon mean ha he applicaion of inegral merics is inappropriae in principle and moreover so, if we consider he effec of ime, which muliplies he above forecas inaccuracy. The challenge is o idenify valuaion ools, which will be effecive in such condiions, and deermine he economic requiremens for he applicaion of a full or reduced se of such valuaion ools. 1 Phased Approach o Time Value of Money in Economic Analysis of Invesmen Projecs. 2

4 The need o reconsruc he exising sysem is furher driven by oher significan weaknesses, which shall be addressed in conjuncion wih he implemenaion of a phased approach o ime value of money. The sysem of merics used o selec invesmen projecs for implemenaion will be reliable only wihin adequaely defined limis. The exising base of projec assessmen raios is, in pracice, represened by he discoun rae only. As demonsraed in our previous aricle, he insufficiency of his raio for projec performance assessmen and invesmen projec selecion, as well as he limied scope of is correc applicaion (invesmen projecs financed wih loans) and inadequae merics developed herefore, mean ha here are virually no limis o cu off marginal projecs. An invesmen decision is always a sraegic one. However, he raios used o jusify his decision fail o define he posiion and oulook of a fuure projec in a real economic environmen, is compeiive srengh and abiliy o survive hroughou he payback period and generae sufficien income. The exising heory does no provide for he comparison of invesmen projecs wih bes-in-class peers o esimae he viabiliy of he fuure business. R&D and innovaion companies do no have a suiable insrumen for analyzing he economic performance of heir producs. The general siuaion wih he invesmen assessmen heory raises doubs as o is abiliy o mee he requiremens of economic developmen in all counries. The ime has come for an overall revision and rejecion of he exising se of valuaion ools and raios, and even of he very objec of invesmen assessmen. 1. The sysem of invesmen efficiency assessmen Analysis of sysem merics in erms of funcional adequacy. Our analysis will be based on assumpions ha he exising curren and fuure value mehods are viable ools of esimaing he ime effec. This assumpion will help o idenify oher weaknesses of he exising sysem, unrelaed o mehods of calculaing he ime value of money. We shall begin wih he analysis of disincive feaures and funcionaliy of he basic discouned meric, used by he exising approach o he selecion of efficien invesmen projecs he Ne Presen Value (NPV). To faciliae he undersanding of issues relaed o NPV, we will discus sandard invesmen projecs, which require cerain iniial expendiure (cash ouflow) before any earnings (cash inflow) can be expeced. Invesmens are assumed o be financed wih equiy raher han loans, while he reurn on invesmens consiss of ne income and depreciaion expenses (cash flows). Accordingly, any oher inerim merics, such as sales revenue, he cos of sales, ax expenses ec, are excluded from he calculaions o simplify he NPV formula and is analysis. Annual cash flows will be he same hroughou he whole life of he invesmen projec. Based on he above assumpions, NPV can be expressed as follows: NPV = T p Tc P + a (1 + r) 0 3 Tc K (1 + r) 0, (1) where P and а are he annual ne income and depreciaion in year, К he amoun of invesmens; r discoun rae; Т с and Т o consrucion period and he useful (service) life of he projec (years); T o = T ul useful life of producion asses; Т р projecion horizon. The Ne Presen Value (NPV) represens he sum oal of discouned annual differences beween real (ne of ax, ineres expense ec) cash ouflows and inflows over he projec life. Fuure coss and earnings are discouned o heir presen value as of he proposed projec commencemen dae. I is generally believed ha if he resuling NPV is posiive, he reurn on invesmen is above he discoun rae and he invesmen projec can be considered accepable. If NPV is zero, he reurn

5 is equal o he discoun rae, and he income earned will be jus sufficien o cover obligaions o crediors. When NPV is negaive, a projec shall be rejeced. Naurally, he higher is NPV, he more profiable and less sensiive o risk facors is he projec. NPV is a convenien meric, since i can be applied when alernaive projecs are available and when a single invesmen projec is analyzed. In he laer case, posiive or zero NPV confirms ha he assumed discoun rae limi can be exceeded successfully, so ha a posiive invesmen decision can be made, subjec o cerain oher facors. The above is a common undersanding of NPV. To undersand, wheher NPV can be accepable as a hreshold o cu off low efficiency projecs, we used formula (1) o idenify he amoun of annual ne income (and, nex, he reurn on projec asses), which corresponds o equal discouned projec coss and earnings (NPV = 0), for a producion upgrade projec, here annual depreciaion expenses depend direcly on service lives of equipmen, producion line ec. (а=к/t o ), while he amoun of curren asses remains he same and does no have o be increased. The required changes o he formula (1) are as follows: Tp P + a Tc K + + (1 r) (1 r) If 1 (1+ r) = α T c, = kc 0 α, Tc he expression can be furher simplified as follows: P К k o 0 (P+а)k o Кk c, Pk o Кk c аk o ; if а = k P c 1 k, and, finally, = ROI min К Т o c Т o T p α = k, while P and а remain he same in each year, o = T c k k o o K, hen Pk0 Кk c - T o Kk o, The minimum rae of reurn on projec invesmens, which ensures ha NPV=0 and he invesmen projec can be acceped for implemenaion, can be represened by he following expression: k c 1 ROI min 100%, (2) k Т o o where k с is he sum of discoun raes for he projec consrucion phase and k o is he sum of discoun facors applied hroughou he operaional phase. The able below summarizes he minimum reurn on projec asses, required o ensure he payback of loans raised o finance invesmens ino producion upgrade (NPV=0), according o formula (2) and assuming he discoun rae in he range of (r = 2 8%) and he useful lives of acive producion asses of 8 and 14 years, respecively (Table 2). According o he above daa, he rae of reurn on plan and equipmen (including depreciaion expense), sufficien o repay he invesmens ino plan upgrades, hardly depends on he service life of equipmen ranging from 8 o 14 years (a ime inerval ypical of mos producion asses) a he mos probable discoun rae of 4-8% for developed economies. On he oher hand, he quoed minimum raes of reurn on asses for producion upgrade projecs, which se a profiabiliy Т o 4

6 hreshold for a projec and deermine wheher he projec will be acceped or rejeced, are surprisingly low, wih ROI min of merely 2.3-5% (a Т o = 8-14 years). However, he pracice demonsraes ha he rae of reurn on invesmens in he range of 10-20% is quie common for producion upgrade projecs. Bu in he siuaion where acual resuls exceed esimaed arges mulifold, here are no grounds o believe ha he NPV meric is an effecive ool o screen ou low-efficiency invesmen projecs. On he oher hand, an economic siuaion ypical of a fuure business a NPV=0 will only mean ha cash inflow of an invesmen projec is equal o is cash ouflow. A he same ime, i will be caasrophic from an invesor s and a business owner s perspecive. Thus, NPV shall be increased, bu o which amoun? The decision is delegaed o business owners or heir professional advisors and, consequenly, excluded from he scope of he exising projec assessmen mehodology, which is oally unaccepable. The invesmen assessmen sysem acceped in all developed economies, in essence, canno be considered as such, since, insead of esimaing he efficiency of an invesmen projec, i requires a projec o correspond o a lower level of reurn ypical of deb capial (financial markes). The direc confirmaion of his fac can be seen in he inernal rae of reurn (IRR), which defines he projec s individual (inernal) discoun rae for comparison wih marke raes. The rae of reurn on invesmens, and is abiliy o mee he manufacurer s requiremens, is no even considered. Consequenly, for businesses wih sufficien funds, which are no ineresed in he crediworhiness of an invesmen projec, he issue of invesmen projec assessmen remains unsolved. As demonsraed by he above, NPV hardly rises o he role of he main projec selecion crieria in he invesmen assessmen mehodology. The exising sysem of invesmen projec analysis fails o funcion properly: i discards only a minor par of unprofiable projecs. Invesmens, as an economic resource, are wased wihou an adequae reurn. Some researches and company analyss do undersand he insufficiency of requiremens se for invesmen projecs by he NPV mehod, if an ineres rae is he only crieria of profiabiliy, and, herefore, adjus he ineres rae by premiums required o finance normal operaions of a business (he paymen of dividends o shareholders, innovaions and business developmen, maerial incenives and social benefis for employees) in addiion o common risk and inflaion premiums. Indeed, his increased discoun rae raises he required level of projec profiabiliy and brings projec selecion crieria o acual business requiremens. However, on he heoreical level, gross problems remain. The concep of value in ime based on opporuniy cos of no invesing ino financial markes also includes he requiremen o avoid excessive opporuniy coss relaed o business operaions. In oher words, NPV is expeced o selec invesmen projecs capable of financing loan repaymen and generaing ne profi sufficien for successful business operaion. Bu if his approach o addressing he issue of a hreshold NPV rae is assumed, i will be hard o undersand how his approach is relaed o he heory of he ime value of money. The resuls of our analysis of he economic scope and informaive value of merics used in he exising valuaion sysem are bes demonsraed by he profiabiliy index (PI). We developed formula (3) o arrive a a high level, simplified discouned profiabiliy index, which, unlike NPV and IRR, ruly reflecs he cos effeciveness (he raio of earnings o coss) of an invesmen projec and is equivalen o he non-discouned ROI meric. The resuling expression is boh high-level and illusraive: i canno be used for pracical purposes, bu helps o undersand he rue essence of he meric. Formula (3) raises serious doubs wheher he heory of invesmen efficiency ruly measures he righ parameers. The discussion below will provide more deails and check wheher our doubs are jusified. 5

7 Invesmens ino producion upgrade and reconsrucion Invesmens ino new asses and plan expansion PI = Т р Тс Т с 0 ( P ±Δ1) ( К ± Δ ) 2 P Т а Т ul ul = P а ; PI = P а + СА /, (3) Т ul where P is annual ne income; а annual depreciaion; CА annual average curren asses; Т ul useful life of producion asses; ±Δ income from he use (no use) of ne income and depreciaion (Δ 1 ) and invesmens (Δ 2 ); К=аТ ul. As can be seen, sripping PI of is ime value raimen exposes is poor economic basis: i is merely a raio of income o depreciaion. If we remember ha he share of depreciaion in he cos srucure (С) in he producion secor is ~5.5% (а=0.055с), hen he sripped PI can be quanified as follows: PI = P 0.055С. The reurn on invesmen can be expressed by he same formula (3), if we replace he annual income in he numeraor wih he oal ne income earned over he service life of asses (he period of uilizing he upfron coss in he denominaor). I is raher difficul o believe ha he bes of invesmen projecs compared will be he projec wih he maximum raio of income o depreciaion. The immediae quesion is why in he assessmen of an invesmen projec is financial resul (profi) is compared o 5.5% of oal coss insead of he aggregae amoun of all producion asses? Is i raional o compare projec profi wih upfron coss (i.e., base he assessmen of an invesmen projec on ROA, or he reurn on asses)? Or, would i be more correc o assume ha projec coss are represened by he cos of producion, namely, he curren cash ouflows, including depreciaion expenses (20 imes he amoun of iniial invesmens), and consider he oal amoun of producion asses (i.e., use he reurn on sales as a basis for projec assessmen)? We believe ha all hese quesions have o be addressed, and will discus hem laer. As demonsraed above, he lack of a ruly funcional cuoff crieria o selec producion projecs for implemenaion means ha he whole group of discouned valuaion merics fails o fully mee he ineress of he real producion secor. This fac divides he exising sysem ino wo groups of merics on he basis of economic ineress in addiion o commonly considered abiliy (or inabiliy) o reflec he ime value of money: discouned merics are used by invesors, while nondiscouned are applied by business owners. However, here is no doub ha business owners working in he real secor also need valuaion merics reflecing he ime value. Consequenly, anoher quesion emerges: why canno he economic analysis of projecs, as praciced currenly, rely on he exising simpler and more accurae mehods? Complex analysis of invesmen projecs based on he sysem of discouned merics represens, essenially, he assessmen of he projec s crediworhiness. A he same ime, he preparaion of a sandard loan agreemen wih a bank (or anoher lending insiuion) includes all necessary calculaion procedures and forms, which regulae loan repaymen and ineres paymens and do no need any discouned merics. Similarly, discouned ools have no pracical value for business owners. Who and why needs he exising sysem of invesmen profiabiliy merics based on he presen value approach? As for non-discouned merics used in he assessmen of real producion projecs, heir applicaion is limied since he raes of reurn on invesmens lack heoreical jusificaion and pracice. The group of non-discouning merics is oo small and fails o cover all ypes of pracical issues, and he role of hese merics in he economic analysis of projecs appears unreasonably resriced. Generally, he exising sysem of invesmen assessmen represens a collecion of 6

8 merics raher han an inegraed sysem hereof, since various merics mee he requiremens of differen users and serve hem poorly in all cases. The above findings and conclusions are based on he assumpion ha he acceped presen and fuure value mehods can acually be used for esimaing he effec of ime on value. The idenified weaknesses in he applicaion of hese mehods o model he movemen of cash flows in ime hroughou he invesmen cycle furher aggravae he inadequacy of all discouned merics and he sysem in general. However, unforunaely, i is eviden ha he ransformaion of NPV and PI ino NPT and PIT, respecively, under he phased approach o value in ime will no be able o overcome organic weaknesses in he sysem of invesmen projec valuaion. Ne Profi-in- Time (NPT) canno be considered a measure of efficiency, boh in srucure and essence. The Profiabiliy Index-in-Time (PIT), while becoming more accurae due o he applicaion of a phased approach o value in ime, will, similarly o PI, represen he raio of profi o depreciaion, which is an unaccepably limied meric in economic erms. Moreover, boh merics (NPT and PIT) canno be sandardized. Thus, in addiion o he improvemen of he exising approach o esimaing he efficiency of invesmen projecs on he basis of he new value in ime mehod, we also need o build an underlying sysem of sandards virually from scrach. Moreover, in view of doubs raised by our analysis of he informaiveness of PI (3), special aenion shall be paid o he reasonableness of undersanding he coss in he PI formula as invesmens made insead of producion coss of an operaional plan. Profiable projec selecion dilemma. To explain our doubs as o he correcness of he very approach o he assessmen of invesmen efficiency, le us analyze he financials of wo businesses manufacuring similar producs (Table 3). Our survey of dozens of dozens of plan execuives and chief economic officers demonsraes ha he firs projec enjoys an unquesionable prioriy. The surveyed said ha in he siuaion of choosing beween wo places of employmen hey would prefer he firs one. The moives for heir preference and assessmens can be summarized as follows: bigger annual income and cash flow srenghen he curren financial posiion and he fuure oulook of he firs projec; while higher sales margin and labor produciviy reflec an efficien use of resources based on innovaive echnology. The reurn on asses was perceived as an insignifican facor. Table 4 summarizes he characerisics of a business creaed under wo invesmen projecs. The firs projec involves he replacemen of an exising producion line wih a more advanced one, while he second projec involves an upgrade of a similar producion line. The useful life of boh producion lines is 10 years; he consrucion period is 2 years. The company has available funds o finance boh invesmen projecs. The objecive is o selec he mos efficien one. To exclude he effec of inflaion, which can complicae he esimaion of value in ime, we shall assume he absence of any inflaion. According o he able, Projec II (IP 2 ) demonsraes higher reurn on invesmens (19.8% vs. 10.5% for Projec I (IP 1 )). However, a final decision in favor of IP 2 based on non-discouned (annual) ROI mus be suppored by a discouned value analysis. Addiional daa required include: he discoun rae (cos of deb) 0.08; useful life of equipmen 10 years; projecion horizon 12 years. In boh invesmen projecs, 50% of he CAPEX budge is spen in each year of consrucion. The valuaion of invesmen projecs under he presen value mehod yields he following resuls: NPV 1 = 1, , = 1,152; PI 1 = 1,152/(4, ) = 0.15 NPV 2 = , = 1,637; PI 2 = 1,637/ (1, ) =

9 The Ne Presen Value and he discouned Profiabiliy Index of IP 2 are significanly higher, which, in combinaion wih a higher rae of reurn on invesmens, clearly indicaes ha IP 2 can be classified as more profiable and shall be seleced for implemenaion. As can be easily seen, Table 3 and Table 4 presen he financials of he same wo projecs. The paradox of he siuaion is ha in he operaional phase experienced managers prefer he firs projec and consider i more profiable. However, invesmen analyss, relying on he exising sysem of valuaion merics, believe ha IP 2 is more efficien and rejec IP 1, which is more promising in he operaional phase. Calculaions based on he proposed phased approach o invesmen valuaion look as follows: NPT 1 = 1, , = 12,549; PIT 1 = 12,549/ (4, ) = 1.3. NPT 2 = , = 7,621; PIT 2 = 7,621/ (1, ) = In absolue erms, he amoun of profi for IP 1 will be significanly larger, bu IP 2 appears much more profiable if he raio of profi o invesed capial is used. Accordingly, we have o sae ha i is sill unclear, which projec is more efficien, Table 5 (daa from Tables 3 and 4). If we consider he resuls of comparison under he NPT approach, IP 1 appears unquesionably he bes. However, NPT, similarly o is counerpar NPV, canno be used as a measure of financial efficiency, as i does no reflec he reurn on RUB 1 of coss. Discouned profiabiliy indices for IP 2 are higher under boh approaches o value in ime, while non-discouned profiabiliy merics are quie opposie: in erms of reurn on asses he leader is IP 2, in erms of reurn on sales IP 1. Under he heory of invesmen efficiency, IP 2 is he bes, wih or wihou he effec of ime. The resuls of analysis discussed in his secion provoke serious reflecions for he following reasons. 1. Financial characerisics of invesmen projecs compared are based on real prooypes: i.e., hey are aken from acual feasibiliy sudies. 2. The broad range of resuls is sunning. Wih he same annual producion oupu, required invesmens ino he innovaion projec IP 1 is 2.76 imes higher han IP 2 requiremens. Moreover, IP 1 has ne income of 1,46x ha of IP 2, depreciaion 4.2x, cash flow 2x (Table 4). 3. The merics of he exising invesmen assessmen sysem demonsrae a clear superioriy of IP 2 : PI 2 is 3.9x PI 1, NPV x NPV 1, ROI 2 1.9x ROI 1 ( Table 5). Sill, managers and oher business praciioners prefer he firs of he wo projecs. As demonsraed by he analyzed case sudy (Tables 3, 4 and 5), he resuls of efficiency analysis of invesmen and business operaions of an invesmen arge do no correspond. Moreover, in pracice, here is a sable endency owards conradicion beween invesmen value based on ROA and key operaing parameers of analyzed projecs. Business ineress jusify higher capial inensiy raio, a rend opposed by he heory. This siuaion seriously complicaes he efficiency analysis of innovaion projecs. The above discussion confirms he imporance of analyzing he issue of invesee s producion efficiency and is posiion in he exising sysem of invesmen efficiency measuremen. Special aenion shall be given o Reurn on Sales, which plays an imporan role in business valuaion and is he only meric (in he exising sysem) demonsraing he benefis of he innovaion IP 1 (Table 5). As can be seen, he sysem of invesmen projec efficiency raios requires ransformaion, firsly, in connecion wih he new approach o value in ime, he need o refine he composiion of raios and improve he undersanding of heir economic subsance and correspondence o he caegory of efficiency and prioriies; and secondly, as a resul of a possible hypoheical change in he inerpreaion of coss for he purposes of projec efficiency assessmen. 8

10 Our approach o he issue of projec selecion. A correc approach o invesmen efficiency analysis can be based on he sysem heory. Therefore, we will begin wih formalizing he posiion, inerrelaion and role of invesmen cycle phases (Figure 1). Generally, he projec life cycle is undersood as an invesmen process period plus an operaion process period, which fall under he projec implemenaion subsysem and he projec operaion subsysem, respecively. A user selecing a projec in accordance wih he acceped mehodology of invesmen efficiency analysis obains informaion on cash inflows and ouflows hroughou he projec life cycle. The weakness of he approach lies in he fac ha profi from he projecs is compared only o he amoun of invesmens (coss incurred in he projec implemenaion subsysem). The scale and efficiency of labor and maerial resources consumed in he process of fuure projec operaion are excluded from he scope of analysis. However, according o he sysem heory, resources consumed in he sysem shall ensure he maximum resul a he oupu of he sysem (in our case, he sysem of producion asses reproducion). The reproducion sysem consiss of wo subsysems: projec implemenaion subsysem and projec operaion subsysem. Reproducion sysem oupu coincides wih he operaion subsysem oupu. Accordingly, he parameers of he operaion subsysem deermine he final resuls of he superior reproducion sysem. The projec implemenaion subsysem has an oupu of is own, measured separaely, bu i represens an inermediae resul wih respec o he combined oupu of he operaion subsysem and he reproducion sysem, and he implemenaion subsysem plays a secondary role as compared o he operaion subsysem (Figure 1). Thus, he assessmen of invesmen projec s efficiency would be objecive only if based on he analysis of operaing efficiency of he projec. We do undersand ha he above conclusion is a principal and very imporan saemen and will ry o commen on is general economic logic wihou any reference o he erms and casual relaionships of he sysem heory. The purpose and ulimae objecive of invesmens is he improvemen of companies operaional efficiency hrough producion upgrade, reconsrucion, expansion and consrucion of new asses. Accordingly, he efficiency of invesmens as a resource is less imporan han he producion efficiency of he invesmen arge. However, he invesmen efficiency heory is based on he underlying assumpion ha he higher he reurn on each ruble invesed ino a projec, he beer. As demonsraed by our analysis, such an assumpion can be rue only from a lender s (bank, invesor, invesmen fund, ec.) poin of view. Economic ineress of paricipans in invesmen projec implemenaion are quie differen. For an invesor, projec requiremens are limied o loan ineres, a a marke or higher rae, and a guaranee of loan repaymen. Since invesors sell invesmens, for hem he ransacion efficiency crierion is a guaraneed marke-average reurn on capial invesed ino he projec. This ineres is expressed by a higher reurn on projec asses as compared o raes of reurn ypical of financial markes. In all siuaions when a projec is implemened for inernal business purposes (even if deb raher han equiy financing is used), he above approach o he assessmen of projec efficiency will be incorrec. A company and a business owner would also be ineresed in smaller projec implemenaion coss and a maximum possible reurn on asses. However, an even more imporan objecive is o ensure ha he operaion of he new projec provides for he mos efficien use of resources, including maerials and labor in addiion o producion asses. The bes projec esimaes and he selecion of he mos efficien projec on he basis hereof imply he choice of he mos raional combinaion of resources used and consumed by he projec. Such a combinaion can be achieved only wih he help of a general raio of economic efficiency. The above discussion demonsraes ha he exising sysem of invesmen efficiency assessmen reflecs he ineress of invesors only and 9

11 fails o serve in full he ineress of invesmen users (companies and business owners) and, ulimaely, of he governmen. A focus on maximizing he resuling effec (NPV) of an invesmen projec or he reurn on invesmens would be jusified if he consequences of an invesmen decision were limied o he invesmen phase, or if he only resource consumed over he operaion phase would be producion asses (or, raher, invesmens ransformed ino producion asses when he projec is pu ino operaion). Under he exising approach, projecs are seleced on he basis of he only raio he reurn on asses. As a resul, i is assumed ha he higher is he reurn on asses (capial invesmens), he beer is he operaing efficiency of he fuure business. However, while he reurn on asses is an imporan raio, i is only one of he hree componens of general business efficiency, and, wihou informaion on he oher wo raios of an operaing enerprise maerials o oupu raio and labor produciviy which have been lef ou, i would be early o make a decision. In pracice, an analysis of invesmens ino a reconsrucion projec can indicae ha in erms of reurn on producion asses such a projec is close o, or even beer han an operaing business, bu is labor produciviy and he maerials-o-oupu raios are worse. In his siuaion, an analys will be formally righ o recommend he invesmen projec for implemenaion on he basis of he exising projec assessmen mehodology, since i demonsraes high reurn on asses, while concerns over he decrease in labor produciviy and maerials-o-oupu raio canno be quanified wihou a general raio of economic efficiency. In an opposie siuaion, an analyzed projec can be found o have a lower reurn on producion asses as compared o an operaing business, while labor produciviy and maerial-o-oupu raio will be significanly higher (see Table 4, for example). Formally, such a projec mus be rejeced since here is no oher way o jusify i in he absence of a general economic efficiency raio. I is very imporan o noe ha he wo opposie cases discussed above are ypical. The firs case describes a projec based on proven and esablished, bu ofen obsolee echnical soluions. As a resul, he projec requires relaively small invesmens, bu canno ensure an efficien use of labor, maerials and energy. The second case is ypical of projecs, which involve he implemenaion of hiech and auomaed producion lines, machinery, equipmen, ec. Such projecs usually promoe echnological progress and ensure he growh of all echnological and economic raios excep for reurn on asses. Obviously, in his siuaion none of he ools of he invesmen efficiency assessmen sysem will be able o suppor a posiive invesmen decision on a projec. We posulae ha he bes invesmen projec can be seleced on he basis of a general producion efficiency raio of an operaing asse. Thus, we need o consider he issue of esimaing producion efficiency and analyze he efficiency of invesmens (and is measuremen) as subordinae o producion efficiency (and is measuremen). Producion efficiency measuremen. Obviously, if he iniial efficiency assessmen of projecs proposed for implemenaion and heir effec on he level of operaing efficiency is incorrec, i would be unwise o expec high final resuls, and he consumpion of resources by such projecs could be unjusified. There are numerous efficiency raios, which deermine wheher any given resource is used reasonably or wheher any aspec of business is raional. However, unless hese local raios are combined ino a single meric, i is impossible o see wheher he siuaion has improved. For example, le s assume ha a company improved labor produciviy by 4% over he year, while he maerials-o-oupu raio remained unchanged, and producion profiabiliy declined by 1%. How has he producion efficiency changed? And here is anoher example. In (unil Gorbachov s reforms, in he period of sable funcioning), he economic developmen of he USSR was characerized by a consisen growh of labor produciviy, sable maerial-o-oupu raios and declining reurn on asses. In 1975, in he Communis magazine, A. Kosygin, Chairman of he USSR Council of Minisers, 10

12 insruced economiss o give a clear definiion of he curren developmen rend, wih is opposie growh of efficiency facors wheher general economic efficiency was improving or declining. Discussions on he issue of producion efficiency commenced in he same 1975, lased over 10 years and had no preceden in erms of scale. Ulimaely, over 100 general producion efficiency raios (GE) were pu forward o express he efficiency crierion (he raio of oupu o coss) in differen ways. The overwhelming majoriy of auhors agreed ha he producion oupu (he numeraor in he producion efficiency formula) shall be undersood as he ne naional produc on he level of naional economy and producion spheres, ne produc on indusry level and ne income on enerprise and producion associaion level. The sronges confronaion occurred on he issue of coss (he denominaor in he producion efficiency formula), which were undersood as he amoun of resources spen (curren producion coss) by some auhors, resources used by ohers and he sum of resources spen and used by he hird. Evenually, he hird poin of view prevailed and gained an increasing number of supporers. Producion efficiency raios calculaed under he hird model were called resource/cosbased, or combined, raios o disinguish hem from cos-based raios in he firs model and resource-based raios in he second. Sill, even he supporers of he resource/cos model of he GE denominaor (full coss) lacked uniy, bu all of hem agreed ha on he enerprise level full coss (denominaor) should be undersood as he annual cos of producion, and he producion efficiency raio (GE) could be expressed as follows: GE P = (4) C + P For he purposes of our sudy, he mos imporan is he general producion efficiency raio (4), where, according o a common opinion of Russian and foreign economiss, full coss are expressed by he cos of producion. In developed economies, he common business pracice is o use he reurn on sales (ROS), which represens he raio of ne income o he cos of producion. Noably, scienific works analyzing he relaive significance of various profiabiliy facors (producion oupu, asses, labor ec.) and heir effec on changes in he financial siuaion of companies emphasize he leading role of he reurn on sales (Torok, Rober M., and Parick J. Cordon 1997). Thus, a general producion efficiency raio (4) is equivalen o a commonly acceped ROS, where ne income correlaes wih full coss (he cos of producion). To make formula (4) sensiive o invesmen coss and obain a more clear expression suiable for invesmen purposes, we arrived a he following expression afer a number of ransformaions: GE i = С i 11 P i + ROI where: P ί, С ί he amouns of annual ne income and operaing coss of an enerprise afer he implemenaion of projec ί; GE ί general producion efficiency raio of invesmen projec ί, GE S sandard (arge) general producion efficiency raio afer projec implemenaion; К ί he amoun of capial invesmens required o implemen projec ί; ROI S sandard reurn on invesmens. The numeraor in he GE i formula is represened by ne income, as appropriae for he assessmen of producion efficiency (ROS). The ROI S К i componen in he denominaor represens a sandard amoun of profi for К i invesmens. Accordingly, annual ne income afer projec implemenaion (P i ) shall be equal or exceed (ROI S К i ). As can be easily seen, he denominaor S К i GE S (5)

13 (С i +ROI S К i ) represens he annual cos of producion afer projec implemenaion calculaed under he cos price model. For he purposes of our sudy, all he above means ha, no maer how paradoxical i may seem in he ligh of curren views, or conradicory o he exising invesmen heory and pracice, he efficiency of invesmens shall be measured by he relaion of he resuling oupu o he fuure cos of producion insead of he amoun of invesmens. This approach allows for measuring he efficiency of an invesmen projec no from an inermediae poin of view (in he ineress of he invesmen phase/invesors), bu from a more general posiion, reflecing he purpose of an invesmen projec in he ineress of he operaing efficiency and he sysem of reproducion. General producion efficiency on enerprise level and for a sand-alone invesmen projec is measured by he reurn on sales (ROS). Le us reierae he key idea of his secion. An invesmen projec is a model of a fuure enerprise or producion business. When a projec is implemened, he model maerializes ino an operaing business, which realizes echnical and economic parameers of he projec hroughou is service life. If we insis on elecing he bes projec on he basis of is reurn on invesmen, as he mos reasonable approach provided, direcly and indirecly in all known mehodologies, hen we have o admi ha oal economic efficiency of any producion enerprise is expressed by is reurn on asses only, while labor produciviy and he maerials-o-oupu raio have no impac on general efficiency and can be used for reference only. For us, such a conclusion is apparenly incorrec. On he oher hand, if he oal efficiency of an operaing enerprise is expressed by a general efficiency raio, i would be logical o apply he same raio o a projec (model) hereof, as invesmens ino inefficien and non-compeiive enerprises and producion businesses are meaningless. From our poin of view, here is no logical explanaion of how he efficiency of an invesmen projec can be reliably measured by he raio of is financial resul o 5.5% of oal producion coss (amorizaion), as is he siuaion when PI (3) is used. On he conrary, we believe i logical o define he coss in he invesmen efficiency formula as he sum oal of producion asses. However, if he undersanding of coss is limied o producion coss only, we will fail o ake ino accoun socially necessary coss, i.e., he cos of goods sold. If we ake ino accoun he fac ha invesmens are a facor which direcly shapes he echnical level of producion and, accordingly, he srucure and amoun of coss, hen we propose o calculae he ne income in he denominaor of he producion efficiency formula (5), which used o arrive a he oal cos amoun in he denominaor of efficiency formulas, on he basis of he raio of capial expendiures o he oal amoun of he invesmen projec, i.e., under he producion model. As can be seen, when a general efficiency raio (GE) is used o measure he efficiency of an invesmen projec, he higher weighing (imporance) of invesmens is explained by he inclusion of wo componens ino he denominaor: radiional ransfer of he amoun of producion asses o he cos of producion via he mechanism of depreciaion, and a rae of reurn o accoun for a posiive effec of invesmens on he effecive use of resources (his effec is currenly inerpreed as reurn on alernaive invesmens), which depends on ROI S and he amoun of invesmens ino a projec. Finally, we can sae ha an assessmen based on a general efficiency raio (GE) ake ino accoun he mulidirecional effec of invesmens on he cos of producion: on he one hand, invesmens increase he coss via depreciaion expenses, on he oher hand, hey reduce i via reduced consumpion of labor, feedsock, maerials, and energy in he producion process. Inclusion of income in he esimaed cos of sales (he denominaor in he GE formula) on he basis of invesmen efficiency muliplies he weighing of invesmens in he efficiency analysis as compared o a formula reflecing only he uilizaion of invesmens (depreciaion). Now ha we have idenified a general producion efficiency raio (5) as he reurn on sales (ROS) and have jusified is imporance as he key meric in he sysem of invesmen efficiency assessmen, we need o address he issue of srucuring he whole sysem of merics. 12

14 Developmen of a subsysem of non-discouned raios. Esimaes based on hese raios rely on local ime inervals, usually, years. They are beer adaped o dynamic changes of ransiional economies and, a he same ime, are an inegral par of invesmen projec selecion in sable (developed) markes. Ou of he hree mos common raios in he group (Table 1) he reurn on invesmens is, doubless, he backbone. Even oday, i could be used as a crieria for selecing efficien invesmen projecs should here be a reasonable mehodological basis for differeniaing he rae of reurn on invesmens in accordance wih he objecive and scope of economic analysis for he whole economy, is secors, sub-secors and various ypes of producion enerprises. In Russia, his raio is no even included ino he exising mehodological guidelines (Minisry of Economy of he Russian Federaion and Minisry of Finance of he Russian Federaion 2000). This siuaion is explained by a endency among heoreicians o diminish he capaciy of nondiscouned raios as insrumens of invesmen efficiency assessmen, moivaed by he inabiliy of hese raios o reflec cash flow changes hroughou he projecion horizon, driven by inflaion, fixed asse depreciaion mehods and oher facors, as well as by heir lack of sensiiviy o ime value of money and he problem of selecing a represenaive momen in ime (year) for assessmen during he operaing phase. However, keeping in mind ha he reurn on invesmens (for an invesmen projec) is direcly comparable o profiabiliy of an operaing enerprise, his raio appears a very convenien and reliable valuaion meric, essenial for developers of new equipmen and echnologies, as well as in he early sages of invesmen projec assessmen. The payback period is a less informaive meric. I is esimaed under a very condiional assumpion ha invesmens ino a projec will be repaid from ne income only. In addiion, i is bu a reverse expression of reurn on invesmens. Invesmen Payback Period (pp) deermines a period in ime, during which he projec is operaed for is own benefi and pays back capial expendiure incurred boh from ne income and depreciaion expenses: К= ( P 1 + а 1 ) + ( P 2 + а 2 ) + + (P Тpp + а Тpp ) (6) where P is ne income for a year; а annual depreciaion expenses; Т pp he period of invesmen payback. The above meric canno measure efficiency, bu is useful in analyzing and closing financial lease ransacions and raising loans, since i deermines he minimum period of loan repaymen. The sysem of marke invesmen valuaion raios lacks a comparaive efficiency raio (annual oal coss), which was used in he Sovie economy. С i +R TC К i min (7) where С i is annual producion cos; К i invesmens ino compared projecs; R TC invesmen efficiency rae. This raio provides for opimum allocaion of invesmens among compeing invesmen opporuniies. Therefore, when federal or municipal programs (or corporae programs involving large-scale implemenaion, i.e. inroducion of grain dryers or mini mea processing facories) wih limied invesmen amoun are developed, he above raio can be used o selec he mos efficien use of available funds among possible invesmen alernaives. Oher spheres of applicaion for he comparaive efficiency raion include environmenal projecs, organizaion of public services and ameniies in he housing secor, ec. A common feaure of hese and similar invesmen projecs is ha hey are non-profi aciviies wih sric invesmen limis, which have o comply wih applicable sandards and echnical condiions. None of raios used in marke condiions will be applicable in hese siuaions. An finally, i shall be noed ha, as demonsraed above, none of raios already discussed, or any oher ool in he curren invenory of he invesmen efficiency heory can saisfy he ulimae 13

15 invesmen objecives of he real secor and reflec he degree of heir achievemen. The group of raios seleced by us will become a rue subsysem of non-discouned raios only afer we add o i a general producion efficiency raio (5). The resuls of invesmen assessmen based on his raio deermine wheher an invesmen projec mees arge requiremens and illusrae comparaive prioriy of rival invesmen projecs. All oher merics in he subsysem characerize separae aspecs of efficien use of invesmens as a local bu scarce resource, as shown above. Developmen of a subsysem of valuaion merics reflecing value in ime. In previous secions we have already demonsraed ha NPV and IRR do no reflec he efficiency of real invesmens (capial expendiure), mainly, because heir srucure does no correspond o a classical expression of efficiency as he relaion of projec income o iniial coss (invesmens), bu also because hese raios assess, albei incorrecly, only he abiliy of an invesmen projec o mee he requiremens of he financial marke and help o prove ha an analyzed projec will ensure he repaymen of invesed capial plus ineres hereon a marke ineres raes. As a resul, hese merics canno be applied as a ool of selecing accepable invesmen projecs in he real producion secor. From invesors poin of view, he issue of analyzing crediworhiness of an invesmen projec can be addressed wih more reliable and proven mehods, which do no involve any assessmen based on discouned raios. To a cerain degree, he sysem of invesmen efficiency assessmen proposed by us will no serve as a basis for projec selecion by invesors, bu he qualiy and financial poenial of invesmen proposals will improve significanly as a resul of higher efficiency and compeiiveness. Thus, he new approach o invesmen projec selecion on he basis of producion efficiency in he operaing phase and a new concep of esimaing value in ime boh necessiae and make possible he developmen of a new group of valuaion merics for invesmen efficiency assessmen adjused for he effec of ime. The sysem of merics relies on elemens (income and coss) modeled under he proposed phased mehod of esimaing he ime value of money 2. Ne Profi in Time (NPT). Le s sar wih he definiion of Ne Profi in Time (ne income of an invesmen projec adjused for he effec of ime), which, in addiion o being a core elemen of invesmen analysis, conains he componens used in oher raios: T p T c Tc 1 T ( 1) Tp NPT = ( P + a )(1 + β ) K (1 + β ) c max (8) Srucurally, his raio is similar o Ne Presen Value. However, unlike NPV, NPT provides a real picure of income flows and amouns by years in he implemenaion and operaion phase of a projec. NPT esimaes for each year in he invesmen cycle serve as a basis for planning business operaions and formulaing business developmen programs. Under he phased approach, he adjusmen for he freezing of funds in he invesmen phase of real producion projecs decreases he esimaed projec income, while increasing he income from alernaive financial invesmens. Accordingly, he analysis of producion projecs mus include heir comparison o benefis from equal financial invesmens (9). This fac was aken ino accoun, when we included NPT in he sysem of valuaion merics. The economic effec E (a correc definiion of he currenly applied NPV) from a simulaneous invesmen of equal amouns ino producion projecs vs. financial invesmens (К=К f ) is expressed as follows: 2 Phased Approach o Time Value of Money in Economic Analysis of Invesmen Projecs. 14

16 E ip Т р T Т c = ( + )( + ) р T ( P a 1 К ( 1 + β ) c = Tc = 0 Тр c 1) β K f ( + ) T 1 β Kf (9) Equal benefi from maerial and financial invesmens defined as equal ne income, adjused for he effec of ime, is obained a E ip =0. Profiabiliy Index-in-Time (PIT) is a raio of invesmens o Ne Profi-in-Time, as adjused for he effec of ime: PIT = ТР Тc Тc ( P + а 1 )(1 + β ) К (1 + β ) Т р Тс ( 1) 1 max PIT helps o rank invesmen projecs by he efficiency of invesmens only, raher han he oal amoun of resources spen and used. This raking is secondary and less meaningful han he ranking based on he general producion efficiency raio. NPT and PIT provide invesors (owners of invesed resources) imporan informaion on invesmen projecs. General producion efficiency raio (GET) can be expressed as follows, using he original formula for annual measuremen (5) and a denominaor ransformed from (С+ ROI S К) ino NC + (а+roi S К): GET = ТР Тc NC + Tр Tc NPT ( а + ROI К )(1 + β ) S Tр GET where NC annual operaing coss ne of depreciaion expenses. General producion efficiency raio (GET) is he core elemen of he sysem, because i reflecs cumulaive resuls of using and spending all producion resources involver, raher han invesmens only, covers he whole projec life cycle insead of any local ime inerval and akes ino accoun he ime value of money. Changes in his raio indicae wheher an invesmen projec is accepable. I has no counerpar in he exising sysem of raios. The numeraor of he expression is he ime value of he oal amoun of ne income for all years of projec operaion see formula (8). The denominaor is he presen value of oal annual cash flows plus annual producion coss (ne of depreciaion expenses). Ne operaing coss are no discouned o presen value since hey represen funds wihdrawn from he sysem of asse reproducion and canno be accumulaed or used o generae addiional income in financial markes. Mehods of calculaing planned (arge) GET S and GE S will be discussed in he nes secion. The group of value-in-ime merics consiss of hree raios: GET, NPT, PIT. The abbreviaions represen key noions in he full definiion of raios, while he las T indicaes value in ime. 2. Assessmen of invesmen efficiency in emerging markes and underdeveloped economies As for he problems ypical of ransiion o a developed marke economy and heir impac on he subjec of our sudy, he following can be saed using Russia as an example. Low living sandards and low profiabiliy of he real secor combined wih a large proporion of loss-making businesses hinder he domesic marke developmen. I is difficul o forecas demand and sales volumes. Cusoms duies are volaile. Prices of goods and services for public consumpion grow. Fuel, power and ransporaion prices also increase seadily. Ani- S (10) (11)