Abstract
The vast majority of corporate finance textbooks presents the problem of investment decisions considering discrete cash flows at the end of each period. However, on several occasions, this assumption does not fit the facts, as in the case of the revenues of large retailers, which tend to be generated almost continuously, instead of at the end of each year. In this paper, we compare the net present value of a typical investment considering both a discrete distribution of expected cash flows and a continuous one. We show that the differences observed depend upon the behavior of the function that describes the cash flows and upon the capital cost used to discount the values. Differences tend to be higher if higher capital costs are used. As a result, riskier projects are more sensitive to the right choice of the cash flow distribution to be used in its appraisal and no method can be considered, a priori, better than the other, as operational, fiscal and accounting aspects may make continuous or discrete cash flows more appropriate to describe practical realities. Thus, the article contributes to better supporting investment decisions and to enriching teaching material addressing the subject of investment decisions.
Highlights
The aim of investment decisions is to identify real assets whose value is higher than their cost of acquisition
The vast majority of corporate finance textbooks presents the problem of investment decisions considering discrete cash flows at the end of each period
We show that the differences observed depend upon the behavior of the function that describes the cash flows and upon the capital cost used to discount the values
Summary
The aim of investment decisions is to identify real assets whose value is higher than their cost of acquisition. In spite of the controversies about its rigidity – especially the ones associated to the Real Options Theory – and about the calculation of the capital cost to be used to discount the future cash flows associated to the project, NPV remains, undoubtedly, the most robust criterion of investment appraisal It relies on the assumption of discrete cash flows at the end of each period, and most corporate finance textbooks (Ross et al, 1995; Brigham & Houston, 2004; Damodaran, 1998; Gitman, 1997) barely mention the possibility that cash flows might be continuously distributed during the investments lifetime.
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