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There are a lot of nuances to constructing a cash flow model which analysts run into when they employ their tools to estimate the NPV of an investment. There are the obvious things like whether the tool allows the correct data to be entered, and how the layout and variables of the model work. There are also the less obvious concerns like the calculation methods and whether you assume a step function or continuous rate function for discounting. This article discusses a few of the key things to consider along the way.

Assuming the layout of your Excel cash flow model is user-friendly, you should consider how the starting cash balance is represented. The value of a project is essentially the current cash or cash-equivalent balance plus all future cash flows with the future discounted by some estimate of riskiness or variability. The current cash-equivalent balance is not discounted but it can have a very large effect on the NPV of the project. Since most investments are made up of some actual cash assets and a variety of non-cash assets like buildings, land, machinery, teams of people, websites, etc. these non-cash assets must have a current valuation that is accurate. However, the economic value some of them may actually be a net present value of that asset's future income. This is particularly true of illiquid investments or assets that don't have a clear market such as installed pipelines or process designs. Therefore you may need to incorporate the results of other models as your starting balance.

Consider the revenue or cash in component of the cash flow model. This is where you define and project the expected cash flows from the project at the top line. For example, what are the periods you are considering? Is it monthly for 2 years or quarterly for 5 years, or some other breakdown by time bucket? You can even mix and match, with the first year being shorter periods and subsequent years being longer segments, but this can get tricky with the discounting calculations. Obviously, you need to have rows for one or more sources of incoming cash flow. You should consider whether these incoming cash sources have different levels of risk. If they do, then you may need to discount each net cash flow stream individually at different rates, basically a separate cash flow model for each income stream, or you can sum them all and discount at a weighted or average rate.

On the expense side of your spreadsheet, the same considerations apply as with the revenue side. You need to have individual rows or groups of rows for each component, and these should be bucketed by time and expense type. Business investments tend to have many more expense items than revenue items, and quite a few expenses are tied directly to revenue generation, such as sales commissions, advertising costs, bank transaction fees, websites, and product collateral. Other costs are considered mandatory for operations and fall in the concept of overhead. These include utilities, rent, administrative salaries, banking fees, etc. Financing costs can be fixed or variable, and typically include interest paid on loans, commissions and bank fees. These should be properly grouped by cost of sales, operations, and financing in the cash flow model.

How depreciation and amortization are treated can be a big component of the NPV the Excel model generates. Most investors look at net earnings before taxes and depreciation, which requires some ingenuity to determine if you're starting from a public company's income statements and balance sheet. The reason the approach works is because it values only the pure cash flows of the business. Depreciation and amortization are tax or asset resale value concepts, not real business operations concepts. By focusing only on the actual cash in and out of the business for things like customer payments, machinery purchases, and financing sources, the investor can see how much tangible cash would actually be generated, then value that cash stream in a pure fashion. Again, it's a real life concept from the perspective of actually running a company, not an accounting perspective. Investors don't typically care about accounting. They care about profits and cash in their pockets.

The manner in which taxes are treated in the cash flow model is extremely important. Do you intend to reinvest the cash or take it out of the investment if positive? Traditional DCF valuation assumes that any positive value will be spent as a reinvestment or will not be taxed. But this is not the case in real life. Many investments do not allow you to reinvest the excess cash generated. In other cases the investor may want to take out the profits, which creates a taxable income stream. This is the case with dividends and bond coupon payments, for example. In these latter situations you need to discount the taxable cash flows and you may be able to deduct depreciation and other tax breaks to the cash flow stream before calculating the taxable cash flows. This can be tricky and varies widely depending on the individual investor's tax regime.

The majority of investments can be valued using the NPV concept and a relatively simple set of calculations. Handling these special considerations in your cash flow model will make your NPV results far more accurate.

Looking for a properly designed cash flow model? Go to http://www.financial-edu.com/cash-flow-valuation-model-for-excel.php for an industrial strength pre-built Excel product you can use for a wide variety of investments.

By Dann Roberts
Article Source: http://EzineArticles.com/?expert=Dann_Roberts