Capital Budget Analysis

Discounted Cash Flow Techniques for Capital Project Evaluation

A discounted cash flow analysis is an important tool in capital budgeting as a means of evaluating proposed projects and comparing the growth potential of cash flows. Relevant incremental cash flows must be considered along with the costs of the investment itself in order to determine if the project is to be accepted or rejected. The considerations for acceptance or rejection of a project or slate of projects are the net present value, internal rate of return, hurdle rate, and profitability index.

Net Present Value

The first consideration is a net present value evaluation for the project. This calculation evaluates a future stream of benefits and expenses by converting them to present values. A discount rate is used to discounted future benefits and the total sum of discounted costs is subtracted form the benefits. The relevant formula for NPV is:

Where

t - the time of the cash flow

n - the total time of the project

r - the discount rate

Ct - the net cash flow (the amount of cash) at that point in time.

C0 - the capitial outlay at the beginning

of the investment time ( t = 0 ) (Wikipedia, 2007)

The discount rate used is typically the weighted average cost of capital for the business. The weighted average cost of capital is calculated as an average of the cost of equity and cost of debt proportioned to the capital structure for a firm.

NPV evaluation determines if a company should accept or reject a project proposal. A project should be accepted when the NPV is greater than zero and rejected when the NPV is less than zero. When projects under consideration are mutually exclusive meaning that acceptance of one projected means the other project or projects cannot be accepted, the project with the greatest NPV should be accepted.

Internal Rate of Return and Hurdle Rate

Internal rate of return is the expected rate of return that can be earned on a capital project. The internal rate of return is calculated as the discount rate that results in a net present value of zero for a series of relevant cash flows and one could expect the IRR to be the rate of growth a project will generate. The IRR is typically an estimate and will often differ with actual implementation of a project. However, stronger growth would still be expected from a project with a greater IRR.

Like the NPV calculation, the IRR evaluation also determines if a company should accept or reject a project proposal. A project should be accepted when the IRR is greater than the rate of return and should be rejected if the IRR is less than the rate of return. When evaluating mutually exclusive project, the project with the greatest IRR should be accepted as, the project with the greatest IRR would be assumed to provide the most cash flow growth.

An IRR calculation for a project can also be compared against prevailing rates of return for alternate investments such as investment in the securities market. If a company cannot generate project alternatives with IRRs greater than the returns that can be generated from alternate investments, it may invest its retained earnings in the market or alternate