Evaluating capital budgeting decision rules: NPV, risk adjustment, and time value

Capital Budgeting

How can we know that: (in term of the initial investments and time of cash flow and the relation between them)

Does the decision rule adjust for the time value of money?

Yes, the decision rules do adjust for the time value of money. This can be accomplished in a variety of different methods. For example, if a NPV calculation is used then the initial investment and the future cash flows will be converted into their present values and summed. Using the present value of future streams of incomes is one way of factoring in the time value of money.

Does the decision rule adjust for risk?

Yes, the decision rule also adjusts for perceived risk in an investment analysis. In a NPV calculation, a percentage rate will be determined which represents the risk free rate plus an additional rate that represents the level of risk in an investment. For example, if the required rate of return is 12% and the NPV is calculated to be zero, then the investors will still receive the 12% return that they planned for. Risk is automatically factored into a NPV calculation.

3. Does the decision rule provide information on whether we are creating value for the firm?

Yes, any positive NPV value means that the firm will create excess value over the required rate of return. For example, if the NPV was calculated to be $10,000 and the required rate of return was 12%, then investors would receive the 12% return as well as 10,000 in added value after the time value of money was considered.

4. What is the relationship between the initial investment and NPV? ( what will increase or decrease)

The initial investment is considered in part of the NPV calculation. It is usually designated as the first cash flow at time zero and is generally a negative value. For example, if a company invests 5,000 in a piece of equipment, then the NPV calculation would show a negative 5,000 at the first cash flow period (usually zero). If the initial investment increases then the NPV will decrease. If the initial investment decreases then the NPV will increase; assuming the other factors remain the same.

5. What is the relationship between the Cash Flow and the time and the NPV? ( what will increase or decrease)

Since holding money today is more valuable than holding money tomorrow, then the farther away from zero the cash flow period is, then the least impact it will have on the NPV calculation. For example, a thousand dollars revenue in year one will increase the NPV value much more than a thousand dollars of revenue collected in year fifty.

6. If we have more than one project with all positive NPV, how could I know which project to accept or reject and what factors I should take in my consideration when I accept any project in both company and investment point view.