A financial evaluation of projects it is the investigation of all the parts of a determined project in order to evaluate if this will have a future performance. Therefore, this prior evaluation will be the way to know if this project will contribute to the objectives of the company 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 probability of project failure. Keep in mind that this evaluation is based on estimated data, so it does not ensure that the project will be a success or a failure.
However, its realization does significantly increase the probability of success, and warns of important factors to be taken into account on the project, such as the time of recovery of the investment, profitability or income and estimated costs.
- 1 characteristics
- 1.1 Cash flow
- 1.2 Financing
- 1.3 Return time of the investment
- 1.4 goals
- 2 Financial evaluation methods
- 2.1 The Net Present Value (VAN)
- 2.2 Internal Rate of Return (IRR)
- 2.3 Recovery Period (PR or Payback)
- 3 Examples
- 3.1 VAN and IRR
- 3.2 Period of Recovery or Payback
- 4 References
The characteristics of this evaluation can vary greatly depending on the type of project. However, all evaluations should touch on the following topics:
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 available cash flow.
Although the company can afford to self-finance the project, in the financial evaluation it is important to treat the project as if it had to finance itself.
Return time of the investment
The time it will take the project to be profitable is another essential information when it comes to evaluating it financially.
If the objectives of the project are not aligned with the vision and mission of the company, it would not make sense to do so.
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 Recovery Period (PR or Payback ).
The Net Present Value (VAN)
The NPV is a procedure that measures the current value of a series of future cash flows (ie income and expenses), which will be originated by the project.
To do this, future cash flows must be introduced in the current situation of the company (updating them through a discount rate) and compared with the investment made in the beginning. If it is greater than this, the project is recommended; otherwise, it will not be worthwhile to carry it out.
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 Payback )
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 time of recovery 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 previously recovered.
On the other hand, the updated values of the cash flows are not taken into account as in the previous methods. This is not the most appropriate, since it is known that the value of money changes over time.
VAN and IRR
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.
To calculate the NPV, we first have to know what kind of interest we have. If we do not have that 20,000 €, we probably ask for a bank loan at an interest rate.
If we have these, we must see what profitability that money would give us in another investment, such as a savings deposit. Therefore, let's say that the interest is 5%.
Following the formula of the VAN:
The exercise would look like this:
VAN = -20000 + 4761.9 + 7256.24 + 8638.38 = 656.52
In this way, we have calculated the current value of the annual income, we have added them and we have subtracted the initial investment.
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 the NPV, clearing 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 Payback
If we have two projects A and B, the recovery period gives us the annual return of each of these. Let's see the following example:
By the technique of the Recovery Period, the most interesting project would be A, which recovers its investment in year 2, while B does in 3.
However, does this mean that the A is more profitable in time than the B? Of course not. As we have said, the Recovery Period only takes into account the time in which we recovered the initial investment of the project; it does not take into account the profitability, nor the updated values through the discount rate.
It is a method that can not be definitive when choosing between two projects. However, it is very useful in combination with other techniques such as the VAN and the IRR, and also to give us a preliminary idea of the return times of the initial outlay.
- López Dumrauf, G. (2006), Applied Financial Calculation, a professional approach , 2nd edition, Editorial La Ley, Buenos Aires.
- Bonta, Patricio; Farber, Mario (2002). 199 Marketing questions . Editorial Norm
- Ehrhardt, Michael C.; Brigham, Eugene F. (2007). Corporate Finance . Cengage Learning Publishers.
- Gava, L.; E. Wardrobe; G. Serna and A. Ubierna (2008), Financial Management: Investment Decisions , Editorial Delta.
- Gómez Giovanny. (2001). Financial evaluation of projects: CAUE, VPN, TIR, B / C, PR, CC .