Time Value of Money applied to Capital Budgeting and Decision Making

Time Value of Money applied to Capital Budgeting and Decision Making

 

  • ·        Discounted Cash Flow Methods – Discounted cash flow methods incorporate the time value of money.  As with any quantitative analysis, it requires making some assumptions: (1) all future cash flows occur at the end of the year.  In reality, companies receive and pay out cash throughout the year. (2) Cash Inflows are immediately reinvested in another project to earn a similar rate of return.  In reality, the projects available for reinvestment will have varying rates of return. (3) All cash flows can be projected with 100% certainty.  Cash flows can vary, but we assume they can be predicted.

 

  • ·        Net Present Value (NPV) – The net present value (NPV) method compares the present value of a project’s future cash flows to the initial cash outflow.  The difference between the present value of cash inflows and outflows is called the net present value.  Before we need to know the discount rate, or the rate that will be used to discount the future cash flows to reflect the time value of money.  The rate used to compute the net present value is sometimes called the required rate of return, minimum rate of return, or hurdle rate. Conceptually, the discount rate should reflect the company’s cost of capital, which is a function of its after tax cost of debt and equity financing (WACC).  In general terms, a positive NPV means that a proposed project will generate a return in excess of the cost of capital, creating economic value for the company and its shareholders.  A negative net present value means that the project will not cover the cost of capital and will reduce the firm’s economic value (destroys shareholder value)

 

 

  • ·        Internal Rate of Return (IRR) – is the rate of return that yields a zero net present value.  General rules with IRR are: (1) If the IRR is greater that the required rate of return, then the NPV is positive; (2) If the IRR is equal to the required rate of return, then the NPV is zero; (3) If the IRR is less than the required rate of return the NPV.  Although it is difficult to find the exact IRR using trial and error, this approach is useful for helping managers understand the relationship between the discount rate, NPV, and IRR