of the plant. The rate of discounting should be increased above this value if we feel
that the project involves risks such as market potential, future obsolescence of the
project, etc.
If, when we use this rate of discounting, the net present value of all future cash
flows exceeds the net present value of all investments (initial and future, if any), the
project is regarded as profitable relative to a passive interest-generating activity. If
the net present value of all future cash flows is less than the net present value of the
investments, the project is relatively less attractive than a passive interestgenerating activity.
One may ask, if a project is attractive at a certain rate of discounting, what would
be the rate of discounting that renders the project unattractive? The break-even rate
of return at which the summation of the net present values of all future cash flows
(inflows) just equals the net present value of the outflows (investments, etc.) is the
so-called internal rate of return (IRR). If, therefore, the IRR exceeds the discounting
rate, the project may be regarded as profitable and economically attractive. If it does
not, the project is not attractive or less attractive. The IRR has no real meaning of its
own; it must always be viewed relative to the appropriate discount rate.
The IRR is also called the discounted cash flow rate of return or DCF rate of
return or DCFRR. Everything else being the same, one can raise or lower the IRR
by adjusting the sale price of the product and, therefore, the projected revenue. If we
then fix the desired IRR, we can calculate the necessary sale price. The desired IRR
should eventually be higher than the discounting rate as explained above.
There is a further complexity. Sometimes, one wishes to examine the overall
return over an extended period – say, 10 or 20 years. Whether we consider an active
activity (i.e., a plant investment) or a passive activity (i.e., a loan to others), the
capital is always returned in discrete parcels over this period. What becomes of this
capital once it is returned? Logically, one can expect that it will be reinvested, but at
what rate? Treatments found in the literature often assume that the capital that is
returned can be reinvested at the same rate of return as the original project. This
tends to be unrealistic, principally for highly profitable projects; a more conservative approach is to assume that the capital that is returned can be reinvested at a then
prevailing rate (constant or varied, depending on the desired complexity) so as to
generate a fund at the end of the economic analysis timeframe. This fund can then
be discounted to time zero to add to the overall cash flow. Depending on the choice
of rates and discount rates, this adjustment can have a positive or negative effect on
the overall analysis.
It is often customary to assume a gradual sales buildup, for example, 60 % of
capacity the first year, 80 % the second year, and 100 % the third year and
thereafter. A simple computer program can easily keep track of this and any other
assumptions. For the sake of simplicity, however, we normally assume a uniform
production capacity over the entire period of 10 or 20 years.
Tax accounting, whenever desired, should be done on an extended discounted
cash flow basis. In this format, it is easier to keep track of such terms as financial
depreciation, tax depreciation, tax liability, taxes paid, carryover losses, investment
758
D.S.J. Jones and P.R. Pujado ´
that the project involves risks such as market potential, future obsolescence of the
project, etc.
If, when we use this rate of discounting, the net present value of all future cash
flows exceeds the net present value of all investments (initial and future, if any), the
project is regarded as profitable relative to a passive interest-generating activity. If
the net present value of all future cash flows is less than the net present value of the
investments, the project is relatively less attractive than a passive interestgenerating activity.
One may ask, if a project is attractive at a certain rate of discounting, what would
be the rate of discounting that renders the project unattractive? The break-even rate
of return at which the summation of the net present values of all future cash flows
(inflows) just equals the net present value of the outflows (investments, etc.) is the
so-called internal rate of return (IRR). If, therefore, the IRR exceeds the discounting
rate, the project may be regarded as profitable and economically attractive. If it does
not, the project is not attractive or less attractive. The IRR has no real meaning of its
own; it must always be viewed relative to the appropriate discount rate.
The IRR is also called the discounted cash flow rate of return or DCF rate of
return or DCFRR. Everything else being the same, one can raise or lower the IRR
by adjusting the sale price of the product and, therefore, the projected revenue. If we
then fix the desired IRR, we can calculate the necessary sale price. The desired IRR
should eventually be higher than the discounting rate as explained above.
There is a further complexity. Sometimes, one wishes to examine the overall
return over an extended period – say, 10 or 20 years. Whether we consider an active
activity (i.e., a plant investment) or a passive activity (i.e., a loan to others), the
capital is always returned in discrete parcels over this period. What becomes of this
capital once it is returned? Logically, one can expect that it will be reinvested, but at
what rate? Treatments found in the literature often assume that the capital that is
returned can be reinvested at the same rate of return as the original project. This
tends to be unrealistic, principally for highly profitable projects; a more conservative approach is to assume that the capital that is returned can be reinvested at a then
prevailing rate (constant or varied, depending on the desired complexity) so as to
generate a fund at the end of the economic analysis timeframe. This fund can then
be discounted to time zero to add to the overall cash flow. Depending on the choice
of rates and discount rates, this adjustment can have a positive or negative effect on
the overall analysis.
It is often customary to assume a gradual sales buildup, for example, 60 % of
capacity the first year, 80 % the second year, and 100 % the third year and
thereafter. A simple computer program can easily keep track of this and any other
assumptions. For the sake of simplicity, however, we normally assume a uniform
production capacity over the entire period of 10 or 20 years.
Tax accounting, whenever desired, should be done on an extended discounted
cash flow basis. In this format, it is easier to keep track of such terms as financial
depreciation, tax depreciation, tax liability, taxes paid, carryover losses, investment
758
D.S.J. Jones and P.R. Pujado ´