A:

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.

RELATED FAQS
  1. What's the difference between weighted average cost of capital (WACC) and internal ...

    Both weighted average cost of capital (WACC) and internal rate of return (IRR) are great measures for assessing value, but ... Read Answer >>
  2. How do I use Excel to get discount rate over time?

    Learn how to calculate discount rate in Microsoft Excel and how to find the discount factor over a specified number of years. Read Answer >>
  3. How do you calculate IRR in Excel?

    Understand how to calculate the internal rate of return (IRR) in Excel and how it's used to determine anticipated yield per ... Read Answer >>
  4. Present Value vs Internal Rate of Return

    NPV and IRR are popular ways to measure the return of an investment project. Learn how net present value and internal rate ... Read Answer >>
  5. Do you discount working capital in net present value (NPV)?

    Learn why changes in net working capital (NPV) should be included in net present value calculations for analyzing a project's ... Read Answer >>
  6. What is the difference between present value and net present value?

    Understand the difference between the present value and net present value calculations and how these formulas are used in ... Read Answer >>
Related Articles
  1. Investing

    Internal rate of return: An inside look

    The internal rate of return can be used to measure an compare capital projects, stock buyback programs, and investments to determine which will yield the most favorable return.
  2. Investing

    Investors Need A Good WACC

    Weighted average cost of capital may be hard to calculate, but it's a solid way to measure investment quality.
  3. Small Business

    How to Calculate Net Present Value (NPV) in Excel

    Learn how to calculating the net present value (NPV) of your investment projects using built-in functions from Excel.
  4. Small Business

    Capital Budgeting

    Capital budgeting is a planning process used by companies to evaluate which large projects to invest in, and how to finance them. It is sometimes called “investment appraisal.”
  5. Investing

    How to calculate required rate of return

    The required rate of return is used by investors and corporate-finance professionals to evaluate investments. In this article, we explore the various ways it can be calculated and put to use.
  6. Investing

    Valuing Firms Using Present Value of Free Cash Flows

    When trying to evaluate a company, it always comes down to determining the value of the free cash flows and discounting them to today.
RELATED TERMS
  1. Hurdle Rate

    A hurdle rate is the minimum rate of return on a project or investment ...
  2. Initial Cash Flow

    Initial cash flow is the amount of money paid out or received ...
  3. Conventional Cash Flow

    Conventional cash flow is a series of inward and outward cash ...
  4. Composite Cost Of Capital

    Composite cost of capital is a company's cost to finance its ...
  5. Discount Rate

    Discount rate is the interest rate charged to commercial banks ...
  6. Capital Investment Analysis

    Capital investment analysis is a budgeting procedure that companies ...
Hot Definitions
  1. Socially Responsible Investment - SRI

    Socially responsible investing looks for investments that are considered socially conscious because of the nature of the ...
  2. Business Cycle

    The business cycle describes the rise and fall in production output of goods and services in an economy. Business cycles ...
  3. Futures Contract

    An agreement to buy or sell the underlying commodity or asset at a specific price at a future date.
  4. Yield Curve

    A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but ...
  5. Portfolio

    A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, also their mutual, exchange-traded ...
  6. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
Trading Center