Business and Economic Analysis: Comparing Cash Flows
Time value of money
Cash flows are compared on a present-value basis: PV = FV/(1+i)^n, with annuities using [(1+i)^n − 1]/[i(1+i)^n]. NPV discounts at the hurdle rate (MARR or WACC); accept independent projects with NPV greater than zero. IRR is the rate at which NPV equals zero and is useful for communicating, but ranking mutually exclusive projects by IRR can mislead when scale or timing differ - decide with NPV and confirm with incremental IRR.
Other measures
Payback (simple or discounted) measures liquidity, not profitability, and ignores all cash flow after the payback point. Benefit-cost ratio and ROI are ratio measures sensitive to how costs are defined. Life-cycle costing captures acquisition plus operating, maintenance and disposal costs and is the correct basis for equipment replacement or lease-versus-buy decisions.
Cash flow, tax and depreciation
Depreciation is not a cash flow, but the tax shield it creates is; know straight-line, declining-balance and MACRS conventions. Exclude sunk costs, include opportunity costs and working capital, and keep escalation (price change) separate from the discount rate (cost of money).
Traps
Mixing escalated and constant-dollar cash flows with a discount rate built on the other basis; deducting financing costs from cash flows while also discounting; selecting the shorter-payback option that has a lower NPV; ignoring salvage value or the release of working capital at project end.
Worked example
Invest $100,000; returns of $40,000 per year for three years at 10%. Annuity factor = 2.4869, so PV = $99,476 and NPV ≈ −$524. Reject - a marginal case where precision and the discount rate assumption decide the answer.