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.

Basic Characteristics of the Internal Rate of Return Model

The internal rate of return model allows for the comparison of profitability or growth potential among alternatives. All external factors, such as inflation, are removed from calculation, and the project with the highest return rate percentage is considered for investment.

IRR is the discounted rate (interest rate) point at which NPV equals zero. In other words, the IRR is the point at which the present value cash inflows equal the initial investment cost. To consider investment, IRR needs to meet or exceed the required rate of return for the investment type. If IRR does not meet the required rate of return, the company will forgo investment.

To find IRR using the present value tables, we need to know the cash flow number of return periods (n) and the intersecting present value factor. To calculate present value factor, we use the following formula.

$\text{Present Value Factor} = \dfrac{\text{Initial Investment Cost}}{\text{Annual Net Cash Flows}}$

We find the present value factor in the present value table in the row with the corresponding number of periods (n). We find the matching interest rate (i) at this present value factor. The corresponding interest rate at the number of periods (n) is the IRR. When cash flows are equal, use the Present Value of an Ordinary Annuity table to find IRR.

For example, a car manufacturer needs to replace welding equipment. The initial investment cost is $312,000 and each annual net cash flow is $49,944 for the next 9 years. We need to find the internal rate of return for this welding equipment. The expected rate of return for such a purchase is 6%. In this case, n = 9 and the present value factor is computed as follows.

$\text{Present Value Factor} = \dfrac{$312,000}{$49,944} = 6.247 \text{(rounded)}$

Looking at the Present Value of an Ordinary Annuity table, where n = 9 and the present value factor is 6.247, we discover that the corresponding return rate is 8%. This exceeds the expected return rate, so the company would typically invest in the project.

Present Value of an Ordinary Annuity Table
Rate (/)
Period (n)		1%	2%	3%	5%	8%	10%
	1	0.99	0.98	0.971	0.952	0.926	0.909
	2	1.97	1.942	1.913	1.859	1.783	1.736
	3	2.941	2.884	2.829	2.723	2.577	2.487
	4	3.902	3.808	3.717	3.546	3.312	3.170
	5	4.853	4.713	4.58	4.329	3.993	3.791
	6	5.795	5.601	5.417	5.076	4.623	4.355
	7	6.728	6.472	6.23	5.786	5.206	4.868
	8	7.652	7.325	7.02	6.463	5.747	5.335
	9	8.566	8.162	7.786	7.108	6.247	5.759

If there is more than one viable option, the company will select the alternative with the highest IRR that exceeds the expected rate of return.

Our tables are limited in scope, and therefore, a present value factor may fall in between two interest rates. When this is the case, you may choose to identify an IRR range instead of a single interest rate figure. A spreadsheet program or financial calculator can produce a more accurate result and can also be used when cash flows are unequal.