Net Present Value Project Evaluation

My company is considering a certain project undertaking. Our CFO is uncertain on whether or not to embrace the project. Having estimated the cash flows and NPV for the project, and having an estimated NPV as +$10, I am tasked with the role of analyzing the feasibility of the said project on the basis of the cash flows and NPV estimates. In so doing, I will address the kind of analysis I would make use of to make a case for or against the project and how I would justify my decision.

It is important to note, from the onset, that businesses must ensure that all decisions made with regard to investments are sound. This is more so the case given that in addition to most projects requiring significant capital outlay, once a project commences, it could be quite expensive (or in some instances impossible) to abandon midway. The relevance of making sound investment decisions cannot, therefore, be overstated.

To determine the viability of projects, and hence make a business case for such undertakings, there is need for a deliberate screening process that typically utilizes various appraisal and evaluation methods. The method or approach that I will be taking into consideration as I seek to make a business case for Project X is the net present value (NPV). Payback period will be mentioned as an additional reference point. It is, however, important to note that there are many other methods businesses utilize in project appraisal and evaluation. These include, but they are not limited to, the internal rate of return (IRR) and the return on capital employed (ROCE).

The Net Present Value (NPV), in essence, seeks to analyze a projected or proposed project’s profitability. The parameters used in the computation of NPV are the present values of cash outflows and cash inflows, with the difference between the latter and the former being the net present value. In our case, the estimated net present value was +$10. It is important to note that the NPV value could either be negative, positive, or zero. Project X’s has a positive NPV value. A positive net present value, in the words of Crosson and Needles (2013), means that “the rate of return on the investment will exceed the company’s minimum rate of return, or hurdle rate, and the project can be accepted” (p. 371). In that regard, therefore, Project X could be regarded a viable investment. The positive NPV in this case means that the present value of cash inflows is higher than that of cash outflows. The estimated NPV of +$10 essentially represents a net gain during the period of investment. The figure was arrived at via an estimation of the amount of future cash flows to be generated by the project, whereby the said cash flows were then discounted into a specific present value amount.

It should be noted that although the relevance of NPV when it comes to the measurement of a project’s viability or profitability of an investment cannot be overstated, there approach is not immune to error – largely because of reliance on various estimates and assumptions. Some of the factors that are largely estimates include, but they are not limited to, projected returns and investment costs. This is more so the case given that in some instances, some expenditures may not be clear beforehand, and cash inflow estimates could miss out some key info relating to business risk, which as Li, Hasio and Li (2015) observe is associated with volatile future earnings or cash flows. In the words of Dhiensiri and Balsara (2014), “if these forecasts are inaccurate, the resulting computation of net present value will likely be incorrect, leading to a suboptimal capital budgeting decision.” This approach, however, has some advantages not evident in other investment/project evaluation methods. In the words of Crosson and Needles (2013), “a significant advantage of the net present method is that it incorporates the time value of money into the analysis of proposed capital investments” (p. 371). This is unlike is the case in the payback period method/approach.

In place of the net present value, yet another approach that could come in handy is the payback period. However, as I have pointed out elsewhere in this text, unlike is the case with NPV, the time value of money is not accounted for in payback period. This approach is, however, much simpler than the net present value method as it largely concerns itself with the measurement of the time period an investment or project would take for the costs associated with the said undertaking to be recouped. The simple formula used in the computation of payback period is investment cost divided by annual net cash inflows. In the case of Project X, therefore, a long payback period would necessitate the abandonment of the project. While this approach could be favored for its simplicity, I am of the opinion that it should be used alongside the net present value approach as an extra reference point.