Discounted Cash Flows

1. Discounted cash flow, or DCF, methods account for the time value of money when
determining the viability of projects. This time value is the change in the purchasing
power of the dollar over time. The DCF methods also indicate the opportunity cost
-- that is, the consequences of forgoing alternative investments to make the chosen
investment. The main types of DCF methods are net present value, internal rate of
returns and the profitability index.

Net Present Value

1. Net present value, or NPV, is the difference between an investment’s present value
of cash inflows and its present value of cash outflows. The cash flow estimates are
determined using a market-based discount rate, also know as a hurdle rate, which
accounts for the time value of money. NPV expresses the wealth generation impact
of an investment in dollar terms. The rule of thumb is to accept capital investments
with positive cash flows and reject the ones with negative cash flows. This is
because a positive NPV confirms that the investment’s cash flow will sufficiently
compensate its costs, the cost of financing and the underlying cash flow risks.

Internal Rate of Return

1. Internal rate of return, or IRR, is the rate at which an investment is expected to
generate earnings during its useful life. IRR is actually the discount rate that
pushes the NPV to zero. This is more or less the discount rate at which the present
value of cash outflows equals the present value of cash inflows. Accept a capital
investment if the IRR is greater than the cost of capital, and reject it if the IRR is
lower than the cost of capital.

Profitability Index
1. The profitability index, or PI, is the ratio of an investment’s NPV. It shows the ratio
of the present value of cash inflows to the present value of cash outflows. This
method facilitates the ranking of investments, especially when dealing with mutually
exclusive investments or rationed capital resources. Accept a capital investment
when the PI is greater than 1, and reject it when the PI is less than 1.

Nondiscounted Cash Flows

1. Non-DCF methods do not account for the time value of money; they assume the
value of the dollar will remain constant over the economic life of a capital
investment. The payback period, or PBP, is the only non-DCF method that uses
cash flow estimations. PBP is the duration it takes to recover the initial capital of an
investment. Investments with short PBP are preferred over investments with longer
PBP. However, this method has major shortcomings, because it does not show the
timing of cash flows and the time value of money.
 Risk Analysis
1. Risk analysis is the process of evaluating the nature and scope of expected and
unexpected setbacks that may derail the achievement of investment goals. A
capital budgeting risk is the likelihood of a long-term investment failing to generate
the expected cash flows. Such risks arise from imperfections in future cash flow
estimates, a situation that exposes your business to possibilities of embracing loss-
making capital investments. Always analyze such probable risks and apply the
appropriate risk premiums -- that is, the applicable rate of returns you should earn
for embracing the extra risks.

What Is the Rationale Behind the Net Present Value

Method?
Businesses must observe proper procedures when undertaking long-term
investments to ensure the projected payoff is worth the resource allocation. Capital
investments are costly and their benefits are spread over several years. Employing
appropriate decision-making models when analyzing the costs and benefits of long-
term investment plans is essential. The viability of capital investments can be
ascertained using the net present value method.

Definition and Rationale

1. NPV is a capital budgeting method for comparing the costs and benefits of
proposed investments or projects. To calculate NPV, subtract a project’s present
value of costs from its present value of benefits. NPV primarily seeks to identify the
most viable investment opportunities by comparing the present value of future cash
flows of projects. The rationale behind the NPV method is its focus on the
maximization of wealth for business owners or shareholders.

Absolute Decision Criteria

1. The NPV method provides straightforward criteria for choosing or rejecting
investment projects. Projects with positive NPVs qualify for selection because their
benefits, in terms of target rates of returns, exceed costs. Investments yield zero
NPV when they have equal benefits and costs. This affords businesses the
flexibility to accept or reject such investments. Negative NPVs, on the other hand,
are loss-making investments that must shunned completely.

Time Value of Money

1. Consider for the time value of money -- that is, the future value cash flows -- when
making capital investment decisions. The NPV method uses a compound rate of
return, or present value interest factor, to discount the future cash flows of
investments and account for the time value of money. The PVIF basically converts
the value of a project’s future cash flows into today’s equivalent value. It becomes
 easier to establish the opportunity cost -- that is, the consequences of forgoing
alternative investments -- once the time value of money is ascertained.

Budget Constraints
1. The NPV method enables small businesses to adjust to the challenges of working
with limited financial resources. NPV can be used to rank mutually exclusive or
competing investments to determine the ones that fall within the budgeted limits of
the business. For example, a business entity may have a viable project that falls
beyond its financial capabilities. Undertaking such an investment would be futile
because the business will lack sufficient funds to support it. NPV rankings provide
mechanisms for detecting such discrepancies.

Techniques in Capital Budgeting Decisions

The key to effective decision making is evaluating alternatives and selecting the
most feasible and valuable among the options. Capital budgeting is a quantitative
assessment that involves forecasting future performance to make long-term
investment decisions. Capital budgeting techniques may use data from financial
and operating reports to predict potential performance of corporate investment and
strategic options.

Process
1. The capital budgeting process is generally more formal than evaluations for short-
term investments. In most businesses, this generally involves a five-step process.
The steps include gathering investment ideas, performing a cost-benefit analysis
on the proposed investments, ranking the appeal of each proposed investment,
implementing the selected investment and evaluating the implemented investment.

Payback Period
1. A number of capital budgeting valuation methods exist. The payback period
method is a simple capital budgeting technique that involves calculating the
number of years it will take to recover the initial cash invested. The investment
alternative with the quickest payback is preferred. For example, if choosing among
capital outlays for two new technology investments, the technology that offers the
fastest return on the initial investment would be selected. The technology not
chosen may -- over the long-run -- provide a greater return, but not within the term
of the payback period set by management. In some situations, a short-term
payback period assessment might be required due to the requirement to pay
associated debt obligations.

Internal Rate of Return

1. The internal rate of return is another type of capital budgeting technique. It
measures the yield on investments by discounting the present value of all cash
 inflows against the sum of all cash outflows for an investment to determine the
earnings over the life of a project. In comparing and ranking alternatives, the
project with the highest earning potential is deemed the most desirable. Keep in
mind that the IRR method might reveal no rate of return from a potential
investment. It might also reveal misleading comparisons, say, if the timing of the
cash flows is different for each investment option.

Discounted Cash Flow

1. The discounted cash flow method takes into account the time value of money by
discounting an investment's future return to a present value. The premise of the
time value of money is that a dollar in-hand today is worth more than the same
dollar in the future. In more sophisticated capital budgeting valuations, this discount
is taken into consideration when the present value of the future return is assessed
against the present value of the cash outflows on an investment.