Evaluating a project based on free cash flow

The evaluation of a project is concerned with determining the merits of the project. This evaluation is an assessment of the soundness of the business, of whether the project is economically favourable. Some of the factors that are important to assess are the following: that there is a strategic fit of the project within the company’s current business; that there are opportunities for the products of the project in the

market; that the project is economically viable; and that the project is technically feasible. 

The outcome of the evaluation should be an assessment not only of the intrinsic value of the project proposal but also the suitability of the project within the context of the company. The economic viability of the project is assessed on its free cash flows. The free cash flow is the amount of money that the business generates or consumes. If it generates money, it has a positive free cash flow. Money generated by the business is available to the owners of the business. It can be distributed to the owners as dividends or it can be re-invested in the business. If the business consumes money, the free cash flow is negative. This represents a shortfall in cash, and the managers need to make up this shortfall either by getting money from the owners or by getting it from lenders who loan the money to the company.

The free cash flows are used to calculate measures of the economic attractiveness of the project. These measures can be used as decision criteria to determine whether a project should be recommended for approval. There are a number of measures of the economic attractiveness. Some of these are the payback period, the return on investment, the net present value and the internal rate of return.

One useful way of analysing the free cash flow is to determine the cumulative free cash flow, which is the sum of the free cash flows for all the prior years. The cumulative free cash flow represents the total cash position of the project at that point. Initially, a typical project shows a negative cash position due to the construction and set-up costs. As the project begins to generate and accumulate cash, the cumulative cash position will gradually become more positive. The time taken for the cumulative free cash flow to reach zero is known as the payback period.

The payback period is amongst the oldest of the criteria used for the analysis of the investment decisions. It has the advantage that it is measured in units of time, which are intuitively understood. However, there is no prescription for what a good payback period is. In addition, the money that is promised in the future is less valuable than cash that is actually in hand now.

Another useful method of analysis of the project’s financials is the return on investment. The return on investment is a measure of the project’s ability to generate funds for its investors.