11.4 Use Discounted Cash Flow Models to Make Capital Investment Decisions
3 min read•june 18, 2024
models are essential tools for making smart capital investment decisions. These models help businesses evaluate potential projects by considering the and forecasting future cash flows.
and are two key methods used in these models. They allow companies to compare different investment options and choose the ones that will create the most value for shareholders.
Discounted Cash Flow Models for Capital Investment Decisions
Net present value calculation
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calculates the sum of all future cash inflows and outflows discounted to the present value
Discounting accounts for the using a or ()
NPV formula: NPV=∑t=0n(1+r)tCFt
CFt represents the cash flow at time t (inflows and outflows)
r is the discount rate, typically the required rate of return or cost of capital (WACC)
n denotes the number of periods (years) in the project's life
If IRR exceeds the required rate of return or cost of capital, the project should be accepted (earns more than the minimum required return)
If IRR is below the required rate of return or cost of capital, the project should be rejected (fails to meet the minimum required return)
IRR allows for quick comparison of projects with different initial investments and cash flow patterns (ranking)
Comparison of investment alternatives
NPV and IRR can be used to rank mutually exclusive investment alternatives (projects that cannot be undertaken simultaneously)
Choose the project with the highest positive NPV (maximizes shareholder value)
If NPVs are equal, choose the project with the higher IRR (higher rate of return)
Ensures selection of the most profitable project among competing options (Equipment A vs. Equipment B)
() offers another metric for comparing investment alternatives
PI is the ratio of the present value of future cash inflows to the initial investment: PI=InitialInvestmentPV(FutureCashInflows)
A PI greater than 1 indicates that the project should be accepted (benefits exceed costs)
When comparing mutually exclusive projects, choose the one with the highest PI (most profitable per dollar invested)
Useful when is constrained and projects must be ranked based on profitability (limited funds)
Limitations of IRR and PI should be considered
IRR assumes that cash inflows are reinvested at the IRR, which may not be realistic (reinvestment rate assumption)
Overstates the actual return if the reinvestment rate is lower than the IRR (common scenario)
PI does not consider the scale of the investment, which may lead to incorrect decisions when comparing projects of different sizes (bias towards smaller projects)
A smaller project with a higher PI may be chosen over a larger project with a lower PI but higher NPV (suboptimal decision)
Additional considerations in capital investment decisions
Time value of money is a fundamental concept in discounted cash flow analysis
processes involve evaluating and selecting long-term investment projects
should be factored into investment decisions
is essential for understanding potential variability in project outcomes