Capital Budgeting: Long Range Planning

Project selection: Net present value method

In this section, you learn to calculate the net present value of capital projects. Then you learn how to use the profitability index to evaluate projects costing different amounts. The profitability index is a refinement of the net present value method.

The net present value method uses the company's required minimum rate of return as a discount rate and discounts all expected after-tax cash inflows and outflows from the proposed investment back to their present values. The net present value of the proposed investment is the difference between the present value of the annual net cash inflows and the present value of the required cash outflows.

In many projects, the only cash outflow is the initial investment, and since it occurs immediately, the initial investment does not need to be discounted. Therefore, in such projects, a company may compute the net present value of the proposed project as the present value of the annual net cash inflows minus the initial investment. Other types of projects require that additional investments, such as a major repair, be made at later dates in the life of the project. In those cases, the company must discount the cash outflows to their present value before comparing them to the present value of the net cash inflows.

A major issue in acknowledging the time value of money in the net present value method is determining an appropriate discount rate to use in computing the present value of cash flows. Management requires some minimum rate of return on its investments. This rate should be the company's cost of capital, but that rate is difficult to determine. Therefore, under the net present value method, management often selects a target rate that it believes to be at or above the company's cost of capital, and then uses that rate as a basis for present value calculations.

To illustrate the net present value method, assume Morris Company is considering a capital investment project that will cost USD 25,000. Morris expects net cash inflows after taxes for the next four years to be USD 8,000, USD 7,500, USD 8,000, and USD 7.500» respectively. Management requires a minimum rate of return of 14 per cent and wants to know if the project is acceptable. The following analysis uses the tables in the Appendix at the end of this text:

Because the present value of the net cash inflows, USD 22,630, is less than the initial outlay of USD 25,000, the project is not acceptable. The net present value for the project is equal to the present value of its net cash inflows less the present value of its cost (the investment amount), which in this instance is -USD 2,370, calculated as (USD 22,630 - USD 25,000).

When a company uses the net present value method to screen alternative projects, it considers the project with the higher net present value to be more desirable. In general, a proposed capital investment is acceptable if it has a positive net present value. In the previous example, if the expected net cash inflows from the investment had been USD 10,000 per year for four years, the present value of the benefits would have been (from Table A.4 in the Appendix):

USD 10.000 X 2.9137= USD29,137

This calculation yields a net present value of USD 4,137, or USD 29,137 - USD 25,000. Since the net present value is positive, the investment proposal is acceptable. However, a competing project may have an even higher net present value.

When comparing investment projects costing different amounts, the net present value method does not provide a valid means by which to rank the projects in order of desirability assuming limited financial resources. A profitability index provides this additional information to management.