The time value of money is important in capital budgeting decisions because it allows small-business owners to adjust cash flows for the passage of time. This process, known as discounting to present value, allows for the preference of dollars received today over dollars received tomorrow. Understanding some common capital budgeting techniques that use the time value of money can help you understand why this concept is so important in capital budgeting decisions.
Net Present Value
The net present value method uses the time value of money to determine whether a project is profitable, even after adjusting for the time value of money. To perform this test, a small-business owner would first determine the cash inflows and outflows required for the project. Once identified, these figures are adjusted to present value and their difference is determined.
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If the project's net present value is greater than or equal to zero, the project is acceptable, as it provides a return greater than or equal to the company's acceptable rate of return. If the owner does not use the time value of money to discount cash inflows and outflows, projects with a long time horizon or in periods of a high discount rate could be mispriced, and the owner could make an unprofitable decision.
Internal Rate of Return
The internal rate of return method applies the net present value method in reverse. This method finds the discount rate, given the undiscounted cash flows of the project, which results in a net present value of zero. The zero point represents the break-even point of project profitability.
To apply this method, a manager divides the investment required by a project by the net annual cash inflow the project is expected to produce. This calculation yields the internal rate of return factor. This factor can be looked up in a net present value table to discern the appropriate internal rate of return. This internal rate of return is then compared with the company's minimum acceptable rate of return. If the project promises a higher return, it is accepted.
Total Cost Approach
The total cost approach allows small-business owners to evaluate multiple projects at one time. In this method, the manager adjusts all cash inflows and outflows for each competing alternative and then compares them. All projects with positive net present values are acceptable; however, the project with the greatest net present value is the most profitable. This method can be time-consuming, because costs that do not differ across competing projects are calculated, even though they are irrelevant.
Project Profitability Index
When funds available for projects are limited, a small-business owner can calculate the project profitability index, or PPI, to determine which project is preferred. By dividing the net present value of a project by the investment preferred, the owner is calculating a value of net present value obtained per dollar invested. This is known as the PPI. Higher project PPI values imply more desirable projects.