Capital is invested in the most lucrative projects to promote the growth of the company. This is particularly the case when debt capital projects are financed because debt payments are required by law, regardless of operating income. The net present value (NPV) calculation is used when budgeting capital to determine which projects generate the highest return. Although there is no set rule about how much debt there is too much, the NPV calculation is a good indication of whether a particular option is worth the cost of the debt needed to finance it.
The NPV formula takes into account the time value of money by discounting future cash flows with a fixed interest rate. This percentage, called the hurdle rate, is the minimum acceptable rate of return for a project to be implemented. Because the money earned on the road is less valuable to a company than the current income generated, the NPT reflects the actual value of the expected return of a particular project by accounting for the lower value of future income and reducing the initial capital investment to pull. In general, a project with a positive NPV is pursued, while those with a negative result probably do not generate enough income to match the cost of the debt needed to finance it
The use of debt financing is also important in determining the profitability of a project because it contributes to the total cost of capital financing of a company. Companies compare their weighted average capital costs (WACC) with the internal profitability (IRR) of a certain project. The IRR is the discount rate that brings the NPV calculation to 0, which means that the sum of all future cash flows is equal to the initial investment. If the IRR of a project is equal to or greater than the WACC, the project must be continued.
The correct amount of debt varies from project to project, so the NPV and IRR calculations determine which projects have the largest potential return on investment relative to the debt they require.