6-steps to build your next project valuation model

July 31, 2023

Building a project valuation model with sensitivities for net present value, internal rate of return, and time to pay back is a critical step for any business owner or manager. This model helps to determine the financial viability of a given project by estimating the expected cash flows and comparing them to the cost of capital. In this blog post, we will describe the steps to build a project valuation model with sensitivities for net present value, internal rate of return, and time to pay back.

Step 1: Identify the Relevant Cash Flows

The first step in building a project valuation model is to identify the relevant cash flows associated with the project. These cash flows include the initial investment, operating cash flows, and terminal cash flows. The initial investment includes the cost of equipment, materials, and other expenses required to start the project. Operating cash flows are the cash inflows and outflows generated by the project during its life cycle, while terminal cash flows are the expected cash inflows or outflows at the end of the project's life.

Step 2: Estimate the Discount Rate

The discount rate is the rate of return required by investors to undertake the project. It is used to discount the future cash flows to present value. The discount rate should reflect the cost of capital, taking into consideration the risk associated with the project.

Step 3: Calculate the Net Present Value (NPV)

The net present value (NPV) measures the difference between the present value of expected cash inflows and the present value of expected cash outflows. A positive NPV indicates that the project is expected to generate a return greater than the required rate of return and is therefore financially viable. If the NPV is negative, the project should not be pursued.

Step 4: Calculate the Internal Rate of Return (IRR)

The internal rate of return (IRR) is the discount rate at which the NPV of the project is equal to zero. This rate represents the return on investment required to undertake the project. If the IRR is greater than the required return, the project is viable.

Step 5: Calculate the Time to Pay Back

The time to pay back is the time it takes to recover the initial investment. It is calculated by dividing the initial investment by the annual cash flows generated by the project.

Step 6: Perform Sensitivity Analysis

Sensitivity analysis involves testing the model's sensitivity to changes in key assumptions and variables. This step helps to identify the most critical assumptions and variables affecting the model's outcome.