Financial Modeling for Management Decisions

          There are many financial models available for use in capital decision making. The models focus on the cash flow associated with an investment and the comparison of that cash flow to expected rates or amounts of return. Because most decisions involve long time periods, financial models are designed to isolate relevant cash flows that will change under different alternatives as the basis for decision making.

            The discounted cash flow method is a capital budgeting technique that incorporates the concept of the time value of money. This method measures the inflow and outflow of cash as if it occurred at a single point in time. A company is able to compare the costs and benefits of a proposed long-term project when using this method because all values are approximately discounted to their present values. 

            For example, a corporation is contemplating the purchase of a new machine that will cost $5,000 and be usable for 5 years. The use of the machine will increase net cash flows by $2,000 per year. If management has declared that no investments are to be made unless they are sure to make an annual return of at least 12%, the discounted cash flow method can aide in the decision. The annual net cash inflow over five years is $2,000 per year. Management can multiply the cash inflow by the present value annuity factor for 12% to see the present value of these cash flows. The present value will then be compared to the cost of the machine to see if the investment should be made.

            Discounted cash flow methods can be split into more specific categories when certain criteria are considered. For instance, the net present value method can be used when there is no constant rate of return required for each year of the project, and the internal rate of return can be calculated as a comparison for the target rate of return set by management.

            The payback period method is another option that is useful in making management decisions. This method signifies the amount of time an investment needs to return its initial investment. The focus is specifically on liquidity, as the payback period is the time actually required for the after-tax cash inflows to recover the initial cost of a project. In contrast to the discounted cash flow methods, the payback method is simple and does not use complex mathematical formulas. However, the time value of money is not taken into consideration, and therefore, total project profitability is ignored.