Project Evaluation in Practice

Four basic steps define the practice of capital budgeting. The first and most obvious is development of a comprehensive model, based upon the best available data, that accurately describes the operational and financial structure of the investment. The model is then used to develop a consistent and realistic assessment of the project’s cash flow potential. The second critical step is determination of an appropriate rate of return to measure the project’s true opportunity cost to the equity investors; in addition, an accurate assessment of the project’s debt capacity as well as its potential cost is required. These two parameters jointly define the relevant capitalisation rate for project cash flows, the third critical element in investment appraisal. The fourth basic step is application of sensitivity analysis to identify those project risks that are most critical to the investment’s success. Once properly quantified, investors can investigate the cost effectiveness of available options for mitigating or eliminating undesirable project risks.