The book refers to a series of cash flows lasting several periods as a stream of cash flows. As with single cash flows, we can represent a stream of cash flows on a timeline. In this chapter we will continue to use timelines and the rules of cash flow valuation introduced in Chapter 3 to organize and then solve financial problems.
The Net Present Value (NPV) method of capital budgeting is by far the most utilized and most accurate method. NPV calculates the present value of cash flows over a period and subtracts the current required outlay (original investment) from the inflows over the period. If the inflows, when adjusted for the interest factor, exceed the original investment; the ...view middle of the document...
A company may have 2 projects that vary greatly in original investment and the total gross income potential for the larger project may look good based on the shear dollars earned but the smaller project may have a greater PI ratio and ultimately be a better investment.
The payback period method is the most simplistic and actually most unrealistic budgeting method in that this method does not take into consideration the time value of money but rather just determines how long it would take to recoup the inital investment. If you put new windows in your home for $5000 and were told that these windows would save your $50 per month in heating bills, the payback method would rationalize that you would break even at the end of your 100th month. When the time value of money is taken into consideration we all know it would take more than 100 months to realize a real break-even point. There is a value associated with this budgeting technique though; this method will give a rough estimate that companies could use to determine if the investment is worth looking into further. If a company is risk-averse, they may not want to invest in anything that would take more than 5 years to recoup. This method would allow this company to easily focus on investment opportunities it would feel more comfortable with. Once it found an investment that meets their payback criteria, it could use a more reliable budgeting technique like NPV.
While NPV is the most reliable budgeting technique, each method has its place in the evaluation process and I suspect many companies utilize multiple methods--some ot narrow down the search and others to select or track current investments.
For example, assuming a discount rate of 5%, the net present value of $2,000 ten years from now is $1,227.83. So if someone offered you $1,000 now or $2,000 ten years from now, you'd pick the latter because its net present value is higher.
Calculating NPV is difficult, in part, because it isn't clear what discount rate should be used, nor is it clear how to project future changes in the discount rate.
Typically, when the term 'constant dollars' is used, it reflects the NPV of historical data using the consumer price index (CPI) as the discount rate. Since the CPI is known in this case, this provides a method of adjusting figures for the effects of inflation.
Since the discount rate reflects the future value of money, it typically has two components: an adjustment for inflation, and a risk-adjusted return on the use of the money. Since market forces typically incorporate inflation adjustments into investment returns and borrowing costs, often the discount rate is keyed to a standard...