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.
Calculation and Discussion of the Results of the Net Present Value Model
To demonstrate NPV, assume that a company, Rayford Machining, is considering buying a drill press that will have an initial investment cost of $50,000 and annual cash flows of $10,000 for the next 7 years. Assume that Rayford expects a 5% rate of return on such an investment. We need to determine the NPV when cash flows are equal. The present value factor (i = 5, n = 7) is 5.786 using the Present Value of an Ordinary Annuity table. We multiply 5.786 by the equal cash flow of $10,000 to get a present value of $57,860. NPV is found by taking the present value of $57,860 and subtracting the initial investment of $50,000 to arrive at $7,860. This is a positive NPV, so the company would consider the investment.
| Present Value of an Ordinary Annuity Table | |||||
| Rate (/) | |||||
|
Period (n) |
1% | 2% | 3% | 5% | |
| 1 | 0.99 | 0.98 | 0.971 | 0.952 | |
| 2 | 1.97 | 1.942 | 1.913 | 1.859 | |
| 3 | 2.941 | 2.884 | 2.829 | 2.723 | |
| 4 | 3.902 | 3.808 | 3.717 | 3.546 | |
| 5 | 4.853 | 4.713 | 4.58 | 4.329 | |
| 6 | 5.795 | 5.601 | 5.417 | 5.076 | |
| 7 | 6.728 | 6.472 | 6.23 | 5.786 | |
Let's say Rayford Machining has another option, Option B, for a drill press purchase with an initial investment cost of $56,000 that produces present value cash flows of $60,500. The profitability index is computed as follows.
|
Based on this outcome, the company would invest in Option A, the project with a higher profitability potential of 1.157.
Now let's assume cash flows are unequal. Unequal cash flow information for Rayford Machining is summarized here.
|
Year |
Net Cash Flow |
|
1 |
$10,000 |
|
2 |
5,000 |
|
3 |
7,000 |
|
4 |
3,000 |
|
5 |
10,000 |
|
6 |
10,000 |
| 7 |
10,000 |
To find the overall present value, the following calculations take place using the Present Value of $1 table.
|
Year |
Cash Flow Amount |
Present Value Factor (i = 5, n = specific year) |
Present Value |
|
1 |
$10,000 |
(i= 5, /7 = 1) = 0.952 |
0.952 x $10,000 = $9,520 |
|
2 |
5,000 |
(i = 5, n = 2) = 0.907 |
0.907 x 5,000 = 4,535 |
|
3 |
7,000 |
(i = 5, n = 3) = 0.864 |
0.864 x 7,000 = 6,048 |
|
4 |
3,000 |
(i = 5, n = 4) = 0.823 |
0.823 x 3,000 = 2,469 |
|
5 |
10,000 |
(i' = 5, n = 5) = 0.784 |
0.784 x 10,000= 7,840 |
|
6 |
10,000 |
(i = 5, n = 6) = 0.746 |
0.746 x 10,000= 7,460 |
|
7 |
10,000 |
(i = 5, n = 7) = 0.711 |
0.711 x 10,000= 7,110 |
|
Total |
$55,000 |
|
$44,982 |
The present value for each period looks at each year's present value factor at an interest rate of 5%. All individual year present values are added together for a total present value of $44,982. The initial investment of $50,000 is subtracted from the $44,982 to arrive at a negative NPV of $5,018. In this case, Rayford Machining would not invest, since the outcome is negative. The negative NPV value does not mean the investment would be unprofitable; rather, it means the investment does not return the desired 5% the company is looking for in the investments that it makes.