In corporate finance, money's time value plays a crucial role in evaluating a project's expected profitability. Because the value of a dollar earned today is greater than its value when earned a year from now, businesses discount the value of future revenues when calculating a project's estimated return on investment. Two of the most commonly used capital budgeting tools that utilize discounted cash flows are net present value, or NPV, and internal rate of return.
For any projects that businesses pursue, they determine a minimum acceptable rate of return, called the hurdle rate, which is used to discount future cash flows in the NPV calculation. Companies often use the weighted average cost of capital, or WACC, as the hurdle rate in capital budgeting because it represents the average cost of each dollar used to fund the project. Projects with the highest NPV figures are generally pursued because they are likely to generate income that far exceeds the cost of capital. Conversely, a project with a negative NPV should be rejected, because the cost of funding exceeds the present value of its returns.
The IRR is the discount rate at which the NPV of a given project is zero. This means the total discounted revenues are exactly equal to the initial capital outlay. If a project's IRR exceeds the company's hurdle rate or WACC, the project is profitable.
For example, assume a project requires an initial investment of $15,000 and generates revenues of $3,000, $12,500 and $15,000 over the next three years, respectively. The company's WACC is 8%. Using the average cost of capital as the hurdle rate, this project's NPV is ($3,000 / ((1 + 0.08) * 1)) + ($12,500 / ((1 + 0.08) * 2)) + ($15,000 / ((1 + 0.08) * 3)) - $15,000, or $10,402. Such a strong NPV indicates this is a highly profitable project that should be pursued. In addition, the IRR calculation yields a rate of 35.7%. This project's profitability is confirmed because the IRR far exceeds the hurdle rate.