FINANCIAL EVALUATION OF PROJECTS: METHODS AND EXAMPLES - DUDAS - 2025

A project financial appraisal is the investigation of all parts of a given project in order to assess whether it will have future performance. Therefore, this preliminary evaluation will be the way to know if the project will contribute to the company's objectives or if it will be a waste of time and money.

The importance of the financial evaluation is that it is prior to any disbursement. Without this, many financial risks of the project would not be considered, increasing the chances of project failure. It must be taken into account that this evaluation is made based on estimated data, so it does not ensure that the project will be a success or a failure.

However, its execution does considerably increase the probability of success, and warns of important factors to take into account about the project, such as the recovery time of the investment, the profitability or the estimated income and costs.

characteristics

The characteristics of this evaluation can vary greatly depending on the type of project. However, all evaluations must address the following topics:

Cash flow

Once operating, the project will generate income and expenses. For each operational year it is necessary to estimate how much will be generated from each other to obtain the flow of funds available.

Financing

Although the company can afford to self-finance the project, it is important in the financial evaluation to treat the project as if it had to finance itself.

Return on investment time

The time it will take for the project to be profitable is another essential piece of information when evaluating it financially.

goals

If the project objectives are not aligned with the vision and mission of the company, it would not make sense to do it.

Financial evaluation methods

There are a large number of financial evaluation methods, of which the best known are: the Net Present Value (NPV), the Internal Rate of Return (IRR) and the Payback Period (PR or Payback).

The Net Present Value (NPV)

The NPV is a procedure that measures the current value of a series of future cash flows (that is, income and expenses), which will be originated by the project.

To do this, the future cash flows in the current situation of the company must be entered (updating them through a discount rate) and compared with the investment that was made in the beginning. If it is greater than this, the project is recommended; otherwise, it will not be worth doing.

Internal Rate of Return (IRR)

The IRR tries to calculate the discount rate that achieves a positive result for the project.

In other words, look for the minimum discount rate for which the project is recommended and will generate a profit. Therefore, the IRR is the discount rate with which the NPV is equal to zero.

Recovery Period (PR or

This method seeks to find out how long it will take to recover the initial investment of the project. It is obtained by adding the accumulated cash flows until they are equal to the initial disbursement of the project.

This technique has some disadvantages. On the one hand, it takes into account only the payback time of the investment.

This can lead to mistakes when choosing between one project and another, since this factor does not mean that the chosen project is the most profitable in the future, but that it is the one that is recovered first.

On the other hand, the updated values ​​of cash flows are not taken into account as in the previous methods. This is not the best option, as the value of money is known to change over time.

Examples

VAN and TIR

Let's take the example that we have the following project to evaluate: an initial cost of € 20,000 that in the next 3 years would generate € 5,000, € 8,000 and € 10,000, respectively.

GO

To calculate the NPV, we first have to know what interest rate we have. If we do not have that € 20,000, we will probably ask for a bank loan at an interest rate.

If we have these, we must see what return that money would give us in another investment, such as a savings deposit. So let's say the interest is 5%.

Following the NPV formula:

The exercise would look like this:

NPV = -20000 + 4761.9 + 7256.24 + 8638.38 = 656.52

In this way, we have calculated the present value of the annual income, we have added it and we have subtracted the initial investment.

IRR

In the case of the IRR, we have previously commented that it would be the discount rate that makes the NPV equal to 0. Therefore, the formula would be that of the NPV, solving the discount rate and equaling it to 0:

IRR = 6.56%

Therefore, the final result is the interest rate from which the project is profitable. In this case, this minimum rate is 6.56%.

Recovery Period or

If we have two projects A and B, the payback period is given by the annual return of each of these. Let's look at the following example:

Using the Payback Period technique, the most interesting project would be A, which recovers its investment in year 2 while B does so in year 3.

However, does this mean that A is more profitable in time than B? Of course not. As we have mentioned, the Recovery Period only takes into account the time in which we recover the initial investment of the project; it does not take into account profitability, nor values ​​updated by the discount rate.

It is a method that cannot be final when choosing between two projects. However, it is very useful when combining it with other techniques such as NPV and IRR, and also to get a preliminary idea of ​​the initial outlay return times.

References

1. López Dumrauf, G. (2006), Applied Financial Calculation, a professional approach, 2nd edition, Editorial La Ley, Buenos Aires.
2. Bonta, Patricio; Farber, Mario (2002). 199 Marketing Questions. Norm Publisher
3. Ehrhardt, Michael C.; Brigham, Eugene F. (2007). Corporate Finance. Cengage Learning Editors.
4. Gava, L.; E. Wardrobe; G. Serna and A. Ubierna (2008), Financial Management: Investment Decisions, Editorial Delta.
5. Gomez Giovanny. (2001). Financial evaluation of projects: CAUE, VPN, IRR, B / C, PR, CC.