Budgeting Basics and Beyond

20.5. Net Present Value

The present value method compares the present value of future cash flows expected from an investment project to the initial cash outlay for the investment. Net cash flows are the difference between forecasted cash inflow received because of the investment with the expected cash outflow of the investment. Use as a discount rate the minimum rate of return earned by the company on its money. As reported in the June 2004 issue of Management Accounting, 45 percent of manufacturers used discount rates of between 13 percent and 17 percent and more than 20 percent used discount rates of over 19 percent.

A company should use as the discount rate its cost of capital.

Rule of thumb: Considering inflation and the cost of debt, the anticipated return should be about 10-13 percent.

NOTE

The net present value method discounts all cash flows at the cost of capital, thus implicitly assuming that these cash flows can be reinvested at this rate.

An advantage of net present value is that it considers the time value of money. A disadvantage is the subjectivity in determining expected annual cash inflows and expected period of benefit.

Recommendation: If a proposal is supposed to provide a return, invest in it only if it provides a positive net present value. If two proposals are mutually exclusive (acceptance of one precludes the acceptance of another), accept the proposal with the highest present value.

NOTE

In an advanced automated environment, the terminal value requires ...