Companies use several techniques to evaluate investments. There are numerous aspects of investment that ought to be taken into account when assessing projects or ventures. Some of these aspects include time value money, future cash flows, and performance metrics. One of the methods that are commonly used to evaluate projects is the net present value (NPV) method. This paper will delve into evaluating a construction project based on the project's 5-year cash flows.
Project Net Cash Flow
Net cash flow is a profitability measurement, and it represents the difference between cash inflows and outflows. Typically, the net cash flow of an investment is an indicator of the project's financial strength (Frank & James, 2014). The concept of net cash flow is utilized to discern the feasibility of a project. A project is viable if it consistently generates positive net cash flow. Conversely, if the net cash flow of the investment is negative, it is an indication that the project or business is having operational or financial issues. However, in some scenarios, negative net cash flow could mean the investment or company is proliferating, and because of this, more working capital is needed.
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Net cash flow is composed of three forms of activities –operating activities, financing activities, and investment activities (Frank & James, 2014). Net cash flow is useful in project selection as it is an indicator of a project's financial strength. It is the fuel that helps projects expand and develop. Net cash flow is essentially what allows projects or businesses to conduct their day-to-day activities. Investors often hunt for projects with positive net cash flows.
With regard to the construction company provided in the scenario, cash flows of the project undertaken by the construction company are positive. The implementation costs of the project are$50,000. The table shown below shows the projected cash flows of the project.
| Year | Cash Flows |
|
1 |
$25,000 |
|
2 |
$35,000 |
|
3 |
$45,000 |
|
4 |
$20,000 |
|
5 |
$15,000 |
Based on these cash flows and the project’s implementation costs, one can determine whether the project will be profitable or not. There are numerous capital budgeting techniques used to evaluate the project. Some of these techniques include the NPV, which makes use of discounted cash flow (DCF principle).
DCF
DCF is a valuation method. Primarily, the DCF method is used to evaluate a project. More specifically, it is used to determine the value of an investment. The valuation is usually based on projected cash flows of the investment (Donbak & Ukav, 2016). DCF is usually utilized to determine the present value (PV) of the cash flows. Typically, the PV is calculated at a given rate, which is usually referred to as the required rate of return. In DFC analysis, the cash flows are discounted for two reasons. The first reason is to adjust to the risk of the project or investment, and the second reason is to account for the time value money Donbak & Ukav, 2016). The calculated PV value is then used to evaluate a potential investment. More specifically, the NPV value of the project is determined by finding the difference between the total PV and the cost of investment. The investment or opportunity ought to be considered if the NPV is positive. Here is the formula for DCF (Donbak & Ukav, 2016);
Where:
The DCF of the construction project was calculated, as shown in Appendix B. The DCF of the project was calculated using the DCF formula and excel functions. The DCF for year 1, 2, 3, 4, and 5 was found to be $20,833.33, $24,305.56, $26,041.67, $9,645.06, and $6,028.16, respectively. The total DCF for the five years was calculated and found to be $86,853.78.
DCF is very useful as it helps estimate the money an investor would receive for investing in a project, based on the PV Principle. In other words, this valuation tool can be a handy tool for investors. This is because it is very helpful for evaluating individual projects.
NPV
NPV is a technique used to analyze the profitability of a project or investment. It is usually calculated by finding the difference between the PV of cash flows. The formula for NPV is (Arshad, 2012):
Where:
As seen in the formula, NPV calculations require three inputs –initial investment outlay, projected cash flows, and appropriate required rate of return. NPV is very helpful as it helps determine how much a project of investment is worth it. This metric takes into account all revenues, expenses, and capital costs associated with a project or an investment. A positive NPV indicates that the project or investment will generate profits, and thus, investors should invest in the project (Arshad, 2012). Conversely, a negative NPV indicates the project or investment will result in a loss. According to the NPV principle, only investments with positive NPVs should be selected.
In the investment project provided for the construction project, the NPV of the project was calculated. The NPV calculation is shown in Appendix C. The NPV of the project was found to be $36,853.78. Since the NPV of the project is positive, the company should consider investing in the company. This is because, based on the NPV calculation, the project is expected to generate profits. The project meets the company requirement, and thus the construction company should invest in it.
Conclusion
As seen, the NPV method is very helpful in terms of evaluation investments. This financial model evaluates the feasibility of potential project investments. With regard to the construction project, the construction company should invest in the project. This is because the NPV of the project is positive, meaning that the project is expected to generate profits. However, it is vital to note that the NPV can be solely used to make the decision as is it is not completely reliant on its own. Other capital budgeting techniques, such as the payback method and the evaluation of the internal rate of return, should be used to evaluate the project.
References
Arshad, A. (2012). Net present value is better than the internal rate of return. Interdisciplinary Journal of Contemporary Research in Business, 4 (8): 211-219.
Donbak, E., & Ukav, I. (2016). Continuing value calculation with discounted cash flows method: An application example for Tekart Tourism Establishment whose shares are dealt with in the Istanbul stock exchange. Journal of Tourism and Hospitality Management, 4 (3):139-145.
Frank, B., & James, O. (2014). Cash flow and corporate performance: A study of selected food and beverage companies in Nigeria. European Journal of Accounting Auditing and Finance Research, 2 (7): 77-87.
Appendices
Appendix A
Net Cash Flows
| Year | Cash Flows |
|
1 |
$25,000 |
|
2 |
$35,000 |
|
3 |
$45,000 |
|
4 |
$20,000 |
|
5 |
$15,000 |
Cash Flows of the Project
Appendix B
Discounted Cash Flow
Year 1
Year 2
Year 3
Year 4
Year 5
Total DCF
Alternatively, the DCF can be calculated using excel functions;
| Implementation Costs |
$50,000 |
|
| Required Rate of Return |
20% |
|
| Cash Flows | ||
| Year | Cash Flows | Discounted Cash Flow ($) |
|
1 |
$25,000 |
20,833.33 |
|
2 |
$35,000 |
24,305.56 |
|
3 |
$45,000 |
26,041.67 |
|
4 |
$20,000 |
9,645.06 |
|
5 |
$15,000 |
6,028.16 |
| Total |
86,853.78 |
Appendix C
Net Present Value (NPV)
