Page 179 - DMGT521_PROJECT_MANAGEMENT

Project Management

Notes return for the firm’s investments on average. When analyzing projects in a capital constrained
environment, it may be appropriate to use the reinvestment rate rather than the firm’s weighted
average cost of capital as the discount factor. It reflects opportunity cost of investment, rather
than the possibly lower cost of capital.
An NPV calculated using variable discount rates (if they are known for the duration of the
investment) better reflects the situation than one calculated from a constant discount rate for the
entire investment duration. Refer to the tutorial article written by Samuel Baker for more detailed

relationship between the NPV value and the discount rate.
For some professional investors, their investment funds are committed to target a specified rate
of return. In such cases, that rate of return should be selected as the discount rate for the NPV
calculation. In this way, a direct comparison can be made between the profitability of the project
and the desired rate of return.
To some extent, the selection of the discount rate is dependent on the use to which it will be put.
If the intent is simply to determine whether a project will add value to the company, using the
firm’s weighted average cost of capital may be appropriate. If trying to decide between alternative
investments in order to maximize the value of the firm, the corporate reinvestment rate would
probably be a better choice.
Using variable rates over time, or discounting “guaranteed” cash flows differently from “at
risk” cash flows, may be a superior methodology but is seldom used in practice. Using the
discount rate to adjust for risk is often difficult to do in practice (especially internationally) and
is difficult to do well. An alternative to using discount factor to adjust for risk is to explicitly
correct the cash flows for the risk elements using rNPV or a similar method, then discount at the
firm’s rate.

Did u know?An NPV calculated using variable discount rates better reflects the situation
than one calculated from a constant discount rate for the entire investment duration.

Self Assessment

State True or False:
5. NPV can be described as the “difference amount” between the sums of discounted: cash
inflows and cash outflows.
6. The CPV of a sequence of cash flows takes as input the cash flows and a discount rate or
discount curve and outputs a price.
7. A firm’s weighted average cost of capital (after tax) is often used, but many people believe
that it is appropriate to use higher discount rates to adjust for risk or other factors.
8. Accounting rate of return or simple rate of return is the ratio of the estimated accounting
profit of a project to its average investment.

9. Average accounting profit is the arithmetic mean of accounting income expected to be
earned during each year of the project’s life time.
10. For some professional investors, their investment funds are committed to target a
unspecified rate of return.

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