The key to this valuation method is that you must adjust the cash flow you expect from the project in the future for both time and risk (item 4 in the figure) in order to be able to analyze what it's worth to you right now. The time factor is straightforward: thanks to inflation and opportunity costs, money you receive in the future isn't worth as much as money in your pocket now.
The risk factor is a bit more complicated. Certainly every investment entails some risk, but some are riskier than others. The goal here is to assess just how risky the project you're considering is, and then to adjust the cash flow you're expecting from the project for that risk. The effect of the calculation, when put in present terms, is to discount the cash you're expecting in the future.
The risk factor referred to, called the annual discount rate, is an adjustment you make to compensate yourself for taking a risk. If you feel the risk of the project is high, then you may assign a discount rate of 50 percent or more on the total value of the project. That's a rate that venture capitalists commonly use when assessing start-up investments. If your risk is low, you may assign a discount rate of 10 percent—about the rate you would assume if you bought a building to house your corporate offices. The further out in time a project's useful life has to run, the larger the discount must be, since the risk compounds. Your company's chief financial officer can help you determine the appropriate discount rate based on your company's cost of capital—the minimum return needed to compensate a company for making an investment in new corporate assets—and other corporate investments.
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What you need to know about… Project Management Made Easy! Project management consists of more than just a large building project and can encompass small projects as well. No matter what the size of your project, you need to have some sort of project management. How you manage your project has everything to do with its outcome.