Alia Rahal works in the financial planning department of a large manufacturing company:
'Financial planning involves calculating whether new projects would be profitable. We have to calculate the probable rate of return: the amount of income we'd receive each year from the investment, expressed as a percentage of the total amount invested. If we're going to finance a project with our own money, the rate of return must be at least as high as we could get by depositing the money in a bank instead, or by making another risk-free investment, like buying government bonds.
If we need to borrow money to finance a new investment, its projected rate of return has to be higher than the cost of capital - the amount we have to pay to borrow the money.'
Discounted cash flows
'We usually calculate the discounted cash flow value of an investment. This means discounting or reducing future cash flows to get their present values - in other words, calculating the present value of money to be received in the future. This is because the value of money decreases over time. Firstly, there's nearly always inflation, so cash will have lower purchasing power in the future: you'll be able to buy less with the same amount of money. And secondly, if you had the money now, you could get income by using or investing it. The return we could get by investing the money in other ways is the opportunity cost of capital. So waiting for money is also a cost. This is the time value of money: how much more it is worth to receive money now rather than in the future.'
Comparing investment returns
if we have to choose among possible investments in new projects, we work out the net present value (NPV) of each project by adding up all the expected cash flows, discounted to their present value, minus the initial investment. To do this, we have to select a discount rate or capitalization rate. This is usually the interest rate we pay for borrowing the capital, but we could increase it if there's a lot of uncertainty or risk.
Discounting sounds complicated, but it isn't. It's the opposite of compounding interest. For example, if you invest $1,000 at 10% for five years, it will yield 1.61 times its original value. So you get back $1,610, including $610 compound interest. A discount rate of 10% has a discount factor of one divided by 1.61, which is 0.62. So $620 invested now will be worth $1,000 in five years if it's invested at 10%.
When we're comparing alternative investments, we also calculate the internal rate of return (IRR). That's the interest rate or discount rate that gives a net present value of zero in today's money values. In other words, the present value of the cash that we're going to receive from an investment is the same as the present value of borrowing that cash. We normally choose the investment with the highest IRR.'
41.1 Match the words in the box with the definitions below. Look at A, B and C opposite to help you.
discounted cash flow
internal rate of return
rate of return
time value of money
1 a series of future earnings converted to their value today
2 the annual percentage amount of income received from an investment
3 the interest rate an investment earns when the present value of all costs equals the present value of all returns
4 the difference between the value of money held now, and its value if it is received in the future, because it could be invested during that period
5 the value of money, measured by the quantity (and quality) of products and services it can buy
6 the interest rate used to calculate the present value of future cash flows
41.2 Are the following statements true or false? Find reasons for your answers in A and B opposite.
1 If a company uses its own money for a new project, there is no opportunity cost of capital.
2 A project financed by borrowed money requires a rate of return higher than the cost of capital.
3 Because of inflation, money will usually be worth more in the future than at the present.
4 The longer you have to wait for investment returns, the less their present value is.
41.3 Match the two parts of the sentences. Look at B and C opposite to help you.
1 Future cash flows are usually discounted
2 If a project seems to be particularly risky or uncertain,
3 Money you possess now is worth more than money received in the future, because
4 The net present value of a project is the sum of all the returns it is cxpected to provide,
5 When choosing among potential investments,
a businesses look for the one with the highest internal rate of return, b by the cost of the capital involved in the investment, c discounted to their current value.
d it can earn interest in that time, and there might be inflation, e you can increase the discount rate you use in your calculations.
Over +o upu
What return can a company get on risk-free investments in your country today? What is the minimum rate of return a company would require on an uncertain new investment?