There are several different decision models that 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 payback period. It should be noted that these are not competitive methods. Everyone has their individual strengths and one is not inherently better than the others. Nor is it about using one against the other. If you’re going to make a capital spending decision that involves a lot 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. In general, it is not considered to be such a good model for decision making. We mention it only because, even with its flaws, it’s still used quite a bit.
1-Net Present Value (NPV): To calculate the NPV of a capital project, we must 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 see shortly, the use of 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. All things being equal, the company would want to undertake a project that promised a positive NPV. Also, if two mutually exclusive projects are being compared, we would like to adopt the one with the higher NPV, again, all else being equal.
Determining the appropriate interest rate to discount the future cash flows of an equity investment is beyond the scope of this book, but essentially that rate is the firm’s total cost of capital. The company’s cost of capital is the rate of return a company must earn to meet its obligations and continue to provide the expected return to shareholders. It can be thought of as the weighted average of a company’s after-tax cost of debt and the return its shareholders currently earn on their investment in the company. It has three components: the company’s after-tax interest rate, the company’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 companies, the cost of capital is between 12 and 18 percent; however, this is a fairly broad generalization. For our purposes, we will assume that we know what the rate is. The important thing to keep in mind is that the company’s cost of capital represents a “hurdle rate.” That is, if a business invests in assets that earn less than its cost of capital, the net worth of the business will decline.
2- Internal Rate of Return (IRR): Remember that we said earlier that using different interest rates will result in different NPVs. The higher the interest rate, the lower the NPV of a project. There will be some interest rate that results in an NPV of zero. That interest rate is the project’s internal rate of return. The present value of cash inflows and outflows is equal when discounted at the IRR of the project. Again, all things 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- Amortization period: The payback period of a capital investment is the time it takes to recover 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 in which we do not discount future cash flows. We can also calculate a discounted payback period where we do.
