This post continues a discussion about cash flow, net present value, interest rates and NPV, and IRR, which you can read by clicking on the specific links. This post deals with the topic of project evaluation.
The main methods used for project evaluation are the NPV method and the IRR method. According to them, an investment project is viable if the NPV is positive or if the IRR is higher than the cost of capital. In most cases these two methods will yield the same conclusion regarding the profitability of a project, and when not, the NPV method is more accurate.
Both the NPV and the IRR of a project depend on the cash flows associated with the project, which in tum depend on many factors: the initial investment(s) required by the project, the revenues to be expected and their evolution in time, the discount interest rate, which in tum depends on the required return on the project, the inflation component and the uncertainty component, etc.
Many times the variables that underlie the project’s cash flows or the interest rate for discount purposes are not known with certainty, so firms estimate them and use the best guessed values to perform the necessary project analysis. Any change in one of these variables compared to the estimated value can affect the NPV of the project or whether the IRR is greater than the cost of capital.
It is therefore necessary to assess the degree of the forecasting risk for these variables and to what extent they might affect the profitability of the project, as well as to identify the variables that are most critical to the success or failure of the project.
Sensitivity analysis investigates what happens to the NPV and IRR of the project when one or more variables change. The idea is that we freeze all the variables except the one(s) analyzed and check how sensitive the NPV and/or the IRR are to changes in that variable. We don’t have specific examples to show you (you can do many scenarios in Excel). However, look back into our cash flow series and familiarize yourself with tools of the cash flow trade.
This post is part of a series of articles on cash flow analysis. Visit our cash flow analysis page to find a summary of each method.