2.5.4 Method Four: Financial Models

Another important series of models relies on financial analysis to make project-selection decisions. Among the more common types of these models are (1) discounted cash-flow analysis, (2) net present value, and (3) internal rate of return. It is important to note that these are not the only financial methods for assessing project alternatives, but they are among the more popular and hence will be the focus for our discussion.

Discounted Cash Flo

The goal of discounted cash flow (DCF) is the estimate outlays and expected inflows of cash due to the investment in a project. All potential costs of development (most are contained within the project budget) are assessed and projected prior to the decision to initiate the project. They are compared with all expected sources of revenue from the project or the operations of the project. For example, if the project is a new chemical plant, the projected revenue streams are based on expected capacity, production levels, sales volume of the chemicals, and so forth.

The discount rate that is applied to this calculation is based on the firm's cost of capital. That value is weighted across each source of capital that the firm has access to. Typically, for example, most public firms acquire capital through either the debt or equity markets; that is, they either take out loans in the form of long-term debt or they float stock offerings in order to raise money through equity. Weighted cost of capital is calculated as

Kfirm = (wd)(kd)(1 - t) + (we)(ke)

The weighted cost of capital for a firm is the percentage of capital derived from either debt (wd) or equity (we) times the percentage costs of debt and equity (kd and ke respectively). The value t refers to the company's marginal tax rate. Because interest payments are tax deductible, we calculate the cost of debt after taxes. Once a cost of capital has been calculated, it is possible to set up a table projecting costs and revenue streams that are discounted at the current cost of capital for the company. The key is to discover how long it will take the firm to reach break-even point on a new project. Obviously, shorter paybacks are more desirable than longer paybacks with their greater risk. For example, consider Table 2.5:

Table 2.5 Revenues and Outlays for Project A and Project B

	Project A		Project B
	Revenues	Outlays	Revenues	Outlays
Year 1		$500,000		$500,000
Year 2	$50,000		$75,000
Year 3	$150,000		$100,000
Year 4	$350,000		$150,000
Year 5	$600,000		$150,000
Year 6	$500,000		$900,000

Clearly, Project A is superior in terms of its cash flow to payback. It is projected that this project will require three years to break even, whereas Project B will not break even until some time after year five. All other things being equal, Project A would be the superior choice.