Page 303 - Analysis, Synthesis and Design of Chemical Processes, Third Edition

We can see from these examples that there are significant effects of discounting the cash flows to account
for the time value of money. From these results, the following observations may be made.
1. In terms of the time basis, the payback period increases as the discount rate increases. In the
above examples, it increased from 3.85 to 5.94 years.
2. In terms of the cash basis, replacing the cash flow with the discounted cash flow decreases the
value at the end of the project. In the above examples, it dropped from $170.5 to $17.12
million.
3. In terms of the cash ratios, discounting the cash flows gives a lower ratio. In the above examples,
the ratio dropped from 1.897 to 1.10.

As the discount rate increases, all of the discounted profitability criteria will be reduced.

Interest Rate Criterion. The discounted cash flow rate of return (DCFROR) is defined to be the
interest rate at which all the cash flows must be discounted in order for the net present value of the project
to be equal to zero. Thus, we can write

DCFROR = Interest or discount rate for which the net
present value of the project is equal to zero

Therefore, the DCFROR represents the highest after-tax interest or discount rate at which the project can
just break even.

For the discounted payback period and the net present value calculations, the question arises as to what
interest rate should be used to discount the cash flows. This “internal” interest rate is usually determined
by corporate management and represents the minimum acceptable rate of return that the company will
accept for any new investment. Many factors influence the determination of this discount interest rate, and
for our purposes, we will assume that it is always given.

It is worth noting that for evaluation of the discounted cash flow rate of return, no interest rate is required
because this is what we calculate. Clearly, if the DCFROR is greater than the internal discount rate, then