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 Internal Rate of Return Model

Assume that Rayford Machining wants to know the internal rate of return for the new drill press. The drill press has an initial investment cost of $50,000 and an annual cash flow of $10,000 for each of the next seven years. The company expects a 7% rate of return on this type of investment. We calculate the present value factor as:

\text{Present Value Factor} = \dfrac{$50,000}{$10,000} = 5.000


Scanning the Present Value of an Ordinary Annuity table reveals that the interest rate where the present value factor is 5 and the number of periods is 7 is between 8 and 10%. Since the required rate of return was 7%, Rayford would consider investment in this metal press machine.


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

Consider another example using Rayford, where they have two drill press purchase options. Option A has an IRR between 8% and 10%. The other option, Option B, has an initial investment cost of $60,500 and equal annual net cash flows of $13,256 for the next seven years. We calculate the present value factor as:

\text{Present Value Factor} = \dfrac{$60,500}{$13,256} = 4.564 \, \text{(rounded)}

Scanning the Present Value of an Ordinary Annuity table reveals that, when the present value factor is 4.564 and the number of periods is 7, the interest rate is 12%. This not only exceeds the 7% required rate, it also exceeds Option A's return of 8% to 10%. Therefore, if resources were limited, Rayford would select Option B over Option A.


Present Value of an Ordinary Annuity Table
Rate (/)

Period (n)

   1% 2% 3% 5% 8% 10% 12%
1 0.99 0.98 0.971 0.952 0.926 0.909 0.893
2 1.97 1.942 1.913 1.859 1.783 1.736 1.690
3 2.941 2.884 2.829 2.723 2.577 2.487 2.402
4 3.902 3.808 3.717 3.546 3.312 3.17 3.037
5 4.853 4.713 4.58 4.329 3.993 3.791 3.605
6 5.795 5.601 5.417 5.076 4.623 4.355 4.111
7 6.728 6.472 6.23 5.786 5.206 4.868 4.564