Use Discounted Cash Flow Models to Make Capital Investment Decisions

Consider that companies will invest in projects that will generate more revenue for the business. This revenue is represented by a stream of future cash flows from the project. We introduced this topic in 3.3: Net Present Value, but it is worth reviewing the idea of future cash flows. When you have studied this section, you will be able to explain how a future stream of cash flows can be appropriately discounted to determine what the value is today.

Use Discounted Cash Flow Models to Make Capital Investment Decisions

Your company, Rudolph Incorporated, has begun analyzing two potential future project alternatives that have passed the basic screening using the non–time value methods of determining the payback period and the accounting rate of return. Both proposed projects seem reasonable, but your company typically selects only one option to pursue. Which one should you choose? How will you decide? A discounted cash flow model can assist with this process. In this section, we will discuss two commonly used time value of money–based options: the net present value method (NPV) and the internal rate of return (IRR). Both of these methods are based on the discounted cash flow process.


Source: Mitchell Franklin, Patty Graybeal, and Dixon Cooper, https://openstax.org/books/principles-managerial-accounting/pages/11-4-use-discounted-cash-flow-models-to-make-capital-investment-decisions
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