There are several different decision models we can use to evaluate proposed capital projects. We want to consider three and mention a fourth. The three that deserve most of our attention are net present value, internal rate of return and the payback period. It should be noted that these are not competing methods. Each has its individual strengths and one is not inherently better than the others. Nor is it a matter of using one versus the others. If you are going to make a capital expenditure decision involving a large amount of money, it only makes sense to look at it from different perspectives. The fourth model we will discuss is the accounting rate of return. It is not generally thought to be as good a model for decision making. We mention it only because, even with its faults, it is still fairly widely used.
1-Net Present Value (NPV): To calculate a capital project’s NPV, we need to first forecast the amount and timing of the cash inflows and outflows associated with the project and then, using the appropriate discount rate, determine the present value of these cash flows. As we will shortly see, using different interest rates will result in different net present values. If the present value of the expected cash inflows is greater than the present value of the expected cash outflows, the project will have a positive NPV. Everything else being equal, the firm would want to undertake a project which promised a positive NPV. Furthermore, if two mutually exclusive projects are being compared, we would want to adopt the one with the highest NPV, once again everything else being equal.
Determining the appropriate interest rate to discount future cash flows from a capital investment is beyond the scope of this book, but essentially that rate is the firm’s overall cost of capital. The firm’s cost of capital is the rate of return a firm must earn in order to meet its obligations and still provide the expected return to stockholders. It can be thought of as the weighted average of a firm’s after-tax cost of debt and the return its stockholders are currently earning on their investment in the company. It has three components: the firm’s after tax interest rate, the firm’s dividend yield and the long-term rate of stock price appreciation. Many corporate finance texts illustrate how the weighted-average cost of capital is calculated.
For many firms the cost of capital lies somewhere between 12 and 18 percent; however, this is a rather broad generalization. For our purposes we’ll assume we know what the rate is. The important thing to keep in mind is that the firm’s cost of capital represents a “hurdle rate.” That is, if a firm invests in assets that earn less than its cost of capital, the net worth of the firm will decrease.
2- Internal Rate of Return (IRR): Recall that we earlier said that using different interest rates will result in different NPVs. The higher the interest rate is, the lower the NPV of a project will be. There will be some rate of interest that results in an NPV of zero. That interest rate is the project’s internal rate of return. The present value of the cash inflows and outflows is equal when discounted at the project’s IRR. Once again, everything else being equal, if the IRR of a project is greater than the firm’s cost of capital, the firm would do well to undertake the project. Likewise, if we are faced with mutually exclusive projects we would select the one with the highest IRR.
3- Payback Period: The payback period of a capital investment is the time it takes to recoup the initial investment in terms of cash flows, that is, when the total cash inflows of an investment equal the total cash outflows. We can calculate a simple payback period where we do not discount future cash flows. We can also calculate a discounted payback period where we do.