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Cash flow analysis techniques
By Raymond Keckler | October 13, 2007
Payback period
This is the time it takes for a company to recoup the initial costs of producing the product. We would compare the initial investment to the incoming cash flows expected over the life of the product. Lets say the initial investment is $500,000. We expect the incoming cash flows to be $100,000 the first year and $200,000 the following years. The payback period is three years.
Initial Investment = $500,000
Incoming Cash flows
- First year = $100,000
- Second Year = $200,000
- Third Year = $200,000
First Year + Second Year + Third Year
$100,000 + $200,000 + $200,000 = $500,000
It will take three years to recoup the initial investment.
This technique has a problem. It does not take into effect the time value of money. Money received in the future is worth less than the money received today. We expect to get some interest in our money when we invest it. It might actually take three and a half years to get back our initial investment with interest.
Discounted Cash Flows
Money received today is worth more than money received in the future. This is because we can invest the money now and receive dividends on that money. So $5,000 invested today at 5% for three years will give me $5788.12 in three years. If I received the $5,000 in three years, I would have lost 4788.12.
The formula is: FV = PV(1+i)^n
FV = future value
PV = present value
i = interest rate
n = number of years
The discounted cash flow technique compares the future value to that of today’s dollar. So we just switch the formula to PV = FV / (1+i)^n
The project that returns the higher value should be chosen.
Net Present Value
This uses the discounted cash flow technique to bring the future monetary value received to today’s dollar value. An NPV with a positive number is a good project. A negative number should not be pursued. In evaluating many projects, the higher NPV number should be chosen. Let’s look at two projects. We will look at each year for three years. The amounts of inflows differ but the total cash flow will be the same. By computing the NPV we can see with project is preferred. The company wants a 12% interest rate.
Project A
| Year | Inflow | PV |
| 1 | 5,000 | 4,464 |
| 2 | 3,000 | 2,393 |
| 3 | 2,000 | 1,424 |
| Total | 10,000 | 8,280 |
| Less investment | - | 8,000 |
| NPV | - | 280 |
Project B
| Year | Inflow | PV |
| 1 | 1,000 | 893 |
| 2 | 4,000 | 3,189 |
| 3 | 5,000 | 3,559 |
| Total | 7,641 | |
| Less Investment | - | 8,000 |
| NPV | - | (359) |
Project A should be accepted because it has a positive NPV and is greater than project B. Project B should not be accepted due to it being a negative NPV. A positive NPV means that the project will earn a return at least equal to or greater than the cost of capital.
–
Raymond Keckler
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Topics: Business, Project Management |