Discounted cash flows in building construction
Discounted cash flow (DCF) analysis is one of the pervasive and fundamental concepts in finance; one of its key advantages is that it usually accounts for the fact that money the money received today can be invested today. It is the critical foundation for valuing financial assets, including building construction and real estate. The discount rate is what a building contractor would want to achieve the level of the risk assumed. It is also essential that blower discount rates are generally applicable to the investments that have lower risk characteristics and higher discount rates; this is mostly applicable to those projects that involve high-risk components like construction (Aboulaich et al., 2016).
The contractor can, therefore, estimate the value of the project based on the future cash flows; this will, in return, help the contractor to figure out the cost of the project today based on the projections of how much money the project is likely to generate in the future. The contractor can first determine whether the project will be a better investment, like launching a new product. He/she should check on the principle that the project being worked on is worth the same amount of all the future cash flows it is likely to produce, with every cash flows getting discounted to their present value. The contractor can ensure that the future cash flows are discounted by the rate that is accounting for the time value of money. He/she can, therefore, make clear decisions between the projects to determine the economic feasibility of that particular project.
The building contractor can use the discounted cash flow to make proper decisions on whether to proceed with a project or to choose between the competing plans. The contractor can, therefore, reject the project if the DCF is less than the initial investment. If the DCF is more significant than the initial investment, then the project has a positive return rate. If he/she is to undertake multiple projects, then the internal rate of return or net present value can be used to select a plan that is having the most excellent rate of return (Aboulaich et al., 2016). The elements that a contractor should also put into consideration is the period used for the evaluation, the annual cash flows that will occur during that time, and the amount of cash that could be earned if it was invested in something else of equivalent risk. A challenge may, however, arise when the project is complicated and broad, the contractor will, therefore, have a problem in accessing the cash flows. The contractor must, consequently, make some assumptions to complete the analysis like ‘what is the right discount rate? Are there available alternatives, or should he rely on the estimated market risk premium?
Contractors can apply the concept of the current value of money to determine whether future cash flows of a project are equal to or higher than the value of the initial investment. The contractor must, therefore, make estimates about the future cash flows and the end value of the project, the equipment, and other assets. He/ she should be able to determine the correct discount rate for the discounted cash flows model that may vary depending on the project that is under consideration. If the future cash flows are not accessed, then the alternative models can be used (Junnila et al., 2015).