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There are several different decision models that we can use to evaluate proposed capital projects. We want to consider three and mention a fourth. The three that deserve the most of our attention are the net present value, the internal rate of return, and the payback period. It should be noted that these are not competitive methods. Each has its individual strengths and one is not inherently better than the others. Nor is it about using one in front of the others. If you’re going to make a capital spending decision that involves a lot of money, it only makes sense to look at it from different perspectives. The fourth model that we will discuss is the accounting rate of return. In general, it is not believed to be a good model for decision making. We mention it only because, even with its flaws, it is still used quite a bit.

1-Net present value (NPV): To calculate the NPV of a capital project, we must first forecast the amount and timing of cash inflows and outflows associated with the project and then, using the appropriate discount rate, determine the present value of these cash flows. As we will see shortly, using different interest rates will result in different net present values. If the present value of the expected cash inflows is greater than the present value of the expected cash outflows, the project will have a positive NPV. All things being equal, the company would want to undertake a project that promised a positive NPV. Also, if you are comparing two mutually exclusive projects, we would like to adopt the one with the highest NPV, once again everything else is the same.

Determining the appropriate interest rate to discount future cash flows from an equity investment is beyond the scope of this book, but essentially that rate is the company’s total cost of capital. The cost of capital of the company is the rate of return that a company must obtain to meet its obligations and still provide the expected return to shareholders. It can be thought of as the weighted average of the after-tax cost of debt of a company and the return that its shareholders currently obtain on their investment in the company. It has three components: the company’s after-tax interest rate, the company’s dividend yield, and the long-term stock price appreciation rate. Many texts on corporate finance illustrate how the weighted average cost of capital is calculated.

For many companies, the cost of capital is between 12 and 18 percent; however, this is a fairly broad generalization. For our purposes, we will assume that we know what the rate is. The important thing to keep in mind is that the company’s cost of capital represents a “cap rate.” That is, if a company invests in assets that earn less than its cost of capital, the net worth of the company will decrease.

2- Internal Rate of Return (IRR): Remember that we said earlier that using different interest rates will result in different NPVs. The higher the interest rate, the lower the NPV of a project. There will be some interest rate that results in a NPV of zero. That interest rate is the project’s internal rate of return. The present value of the cash inflows and outflows is the same when discounted to the project’s IRR. Again, other things being equal, if the IRR of a project is greater than the company’s cost of capital, the company would do well to undertake the project. Likewise, if we are faced with mutually exclusive projects, we would select the one with the highest IRR.

3- Recovery period: The payback period for an equity investment is the time it takes to recover the initial investment in terms of cash flows, that is, when the total cash inflows from an investment equal the total cash outflows. We can calculate a simple payback period in which we do not discount future cash flows. We can also calculate a discounted payback period when we do.

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