Methods for Calculating a Project's Viability
How do you value the financial merits of one project over another? In theory, the investment value models that are used for valuing securities should also be used for valuing capital investments (projects). The problem is that securities are traded in markets like the New York Stock Exchange and NASDAQ. These markets are considered to be efficient for the most part. It is generally accepted that the price (cost) of a security equals its value. There is no efficient market for the buying and selling of projects.
In addition, many projects are predominantly one of a kind or unique. Therefore, there is no relation to the cost (price) of a project and its value. The process of financial evaluation of alternative projects is called capital budgeting. The objective of a project is to create an asset that will in turn create future value. That future value is expected to increase free cash flows.
In his book titled Analysis for Financial Management, Robert C. Higgins indicates that there are three steps to financial evaluation.3 The first step is to establish “relevant cash flows,” which is very much like the budgeting process addressed in Chapter 7. Relevant cash flows should include only incremental after-tax free cash flows. When preparing the relevant cash flows, you should consider how the execution and implementation of the project will affect the company's cash flows. Hence the use of the word “relevant” in describing the cash flows. ...