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. Which is a better measure for capital budgeting, IRR or NPV?

    All other things being equal, using IRR and NPV measurements to evaluate projects often results in the same findings. However, ... 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 use net present value to calculate a capital budget?

    Learn about the net present value calculation (NPV) and how the NPV rule is used in capital budgeting to compare the expected ... Read Answer >>
  4. How do you calculate costs of capital when budgeting new projects?

    Discover how a company should estimate its costs of capital when budgeting for a new business project using the weighted ... Read Answer >>
  5. Why is the Modified Internal Rate Of Return (MIRR) preferable to the regular internal ...

    See why the modified internal rate of return is often a superior metric to the classic internal rate of return for assessing ... Read Answer >>
Related Articles
  1. Small Business

    Capital Budgeting: Which is Better, IRR or NPV?

    Using internal rate of return and net present value for capital budgeting evaluations often end in the same result. But there are times when using NPV to discount cash flows makes more sense.
  2. Small Business

    Calculating the internal rate of return using Excel

    Find out how to calculate the internal rate of return on investments using Microsoft Excel, as illustrated in different investment scenarios.
  3. 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.”
  4. Small Business

    Calculating Net Present Value at Different Points Using Excel

    Calculating the net present value (NPV) of your investment projects using Excel.
  5. 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.
  6. Small Business

    Explaining Cost Of Capital

    Cost of capital is the cost of funds used to finance a business.
RELATED TERMS
  1. Internal Rate of Return - IRR

    Internal Rate of Return (IRR) is a metric used in capital budgeting ...
  2. IRR

    The currency abbreviation or currency symbol for the Iranian ...
  3. Initial Cash Flow

    Initial cash flow is the amount of money paid out or received ...
  4. Profitability Index

    An index that attempts to identify the relationship between the ...
  5. Modified Internal Rate Of Return - MIRR

    While the internal rate of return (IRR) assumes the cash flows ...
  6. Weighted Average Cost Of Capital - WACC

    The calculation of a firm's cost of capital, in which each source ...
Hot Definitions
  1. Receivables Turnover Ratio

    Receivables turnover ratio is an accounting measure used to quantify a firm's effectiveness in extending credit and in collecting ...
  2. Treasury Yield

    Treasury yield is the return on investment, expressed as a percentage, on the U.S. government's debt obligations.
  3. Return on Assets - ROA

    Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets.
  4. Fibonacci Retracement

    A term used in technical analysis that refers to areas of support (price stops going lower) or resistance (price stops going ...
  5. Ethereum

    Ethereum is a decentralized software platform that enables SmartContracts and Distributed Applications (ĐApps) to be built ...
  6. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
Trading Center