Internal Rate of Return (IRR) and

Net Present Value (NPV)

Net present value (NPV): the sum of the present values of all
cash inflows minus the sum of the present values of all
cash outflows.
The internal rate of return (IRR): (1) the discount rate that
equates the sum of the present values of all cash inflows
to the sum of the present values of all cash outflows;
(2) the discount rate that sets the net present value
equal to zero.
The internal rate of return measures the investment yield.
IRR and NPV
Example: Yield on a single receipt.
An investor can purchase a vacant lot for $28,371 and expects
to sell it for $50,000 in 5 years. What is the expected IRR for
this investment?
d = 12%
PV FV
d
n

1
1 ( )
$28, $50,
( )
371 000
1
1
5

d
IRR and NPV
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50000
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P/YR
+ / - PV 28371
1
FV
5 N
I/YR
Clears registers
One payment per year
PV = -$ 28,371
FV = $ 50,000
FV in 5 years
Solve for IRR
IRR and NPV
Example: NPV for a single receipt.
An investor can purchase a vacant lot for $28,371 and expects to sell it for
$50,000 in 5 years. What is the expected NPV for this investment if the
investor discounts future cash flows at 15%?
NPV = -$28,371 + $24,858.84 = - $3,512.16
NPV PV FV
d
n

1
1 ( )
NPV

$28, $50,
( . )
371 000
1
1 015
5
IRR and NPV
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1 P/YR
50,000 FV
15 I/YR
5 N
PV +/-
- 28,371 =
Clears registers
One payment per year
$50,000 future value
Discount rate = 15%
FV in 5 years
Compute present value
Subtract $28,371
IRR and NPV
Example: Yield on an Ordinary Annuity
An investor has the opportunity to invest in real estate costing $28,371
today. The investment will provide $445.66 at the end of each month for the
next 8 years. What is the (annual) IRR (compounded monthly) for this
investment?
PV PMT
d
k
d
d
d
t
t
nk
t
t

1
1
371 44566
1
1
12
12
09167%; 110%
1
1
96
( )
$28, .
( )
. .
IRR and NPV
HP 10B Keystrokes
12
CLEAR ALL
P/ YR
28,371
+/- PV
445.66 PMT
8
I/ YR
x P/ YR
Clears registers
Monthly compounding
PV = - $28,371
Monthly pmt = $445.66
96 months
Compute IRR
IRR and NPV
Example: NPV for an Ordinary Annuity
An investor has the opportunity to invest in real estate costing
$28,371 today. The investment will provide $445.66 at the end of
each month for the next 8 years. What is the NPV for this
investment if the investor discounts future cash flows monthly at a
10% annual rate?
NPV = - $28,371 + $29,369.66 = $998.66
NPV
t
t

$28, .
(
.
)
371 44566
1
1
010
12
1
96
IRR and NPV
HP 10B Keystrokes
CLEAR ALL
12
P/ YR
445.66
PMT
10 I/ YR
8
PV +/-
- 28,371 =
x P/ YR
Clears registers
Monthly payments
Monthly pmt = $445.66
Annual discount rate = 10%
96 monthly payments
Compute PV
Subtract $28,371
IRR and NPV
Example: What is the IRR for an investment that costs $96,000 today and
pays $1028.61 at the end of the month for the next 60 months and then pays
an additional $97,662.97 at the end of the 60th month?
d/12 = 1.0921% ; d = 13.10%
PV PMT
d
k
FV
d
k
d d
t
t
nk
nk
t
t

1
1 1
000 028 61
1
1
12
662 97
1
12
1
1
60
60
( ) ( )
$96, $1, .
( )
$97, .
( )
IRR and NPV
HP 10B Keystrokes
CLEAR ALL
12
P/ YR
96,000 +/- PV
1,028.61 PMT
97,662.97 FV
5
I/ YR
x P/ YR
Clears registers
Monthly payments
PV = -$96,000
Monthly pmt = $1,028.61
FV = $97,662.97
60 months
Compute yield (IRR)
IRR and NPV
Example: NPV for an ordinary annuity with an addition lump
sum receipt at the end of the investment term.
What is the NPV for an investment that costs $96,000 today
and pays $1028.61 at the end of the month for the next 60
months and then pays an additional $97,662.97 at the end of
the 60th month if the investor discounts expected future cash
flows monthly at the annual rate of 13.1047%?
NPV = - $ 96,000 + $ 96,000 = $ 0
NPV PV PMT
d
k
FV
d
k
NPV
t
t
nk
nk
t
t

1
1 1
000 028 61
1
1
0131047
12
66297
1
0131047
12
1
1
60
60
( ) ( )
$96, $1, .
(
.
)
$97, .
(
.
)
IRR and NPV
HP 10B Keystrokes
CLEAR ALL
12 P/ YR
1,028.61 PMT
97,662.97 FV
5
13.1047
I/ YR
PV +/-
- 96,000 =
x P/ YR
Clears registers
Monthly payments
Monthly pmt = $1,028.61
FV = $97,662.97
60 months of payments
Discount rate = 13.1047%
Compute PV
Subtract $96,000
IRR and NPV
Example: IRR for uneven cash flows.
What is the IRR for an investment that costs $100,000 today
and pays $20,000 one year from today; $35,000 two years from
today; and $75,000 three years from today?
$100,
$20,
( )
$35,
( )
$75,
( )
.
000
000
1
000
1
000
1
1159%
2 3

d d d
d
IRR and NPV
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1
100,000 +/- CFj
20,000 CFj
35,000 CFj
75,000 CFj
P/ YR
IRR/ YR
Clears registers
One payment per year
Initial CF = - $100,000
1st CF = $ 20,000
2nd CF = $ 35,000
3rd CF = $ 75,000
Compute yield (IRR)
IRR and NPV
Example: NPV for uneven cash flows.
What is the NPV for an investment that costs $10,000 today,
$8,000 one year from today, $5,000 two years from today and
pays $15,000 three years from today and $25,000 four years
from today if future cash flows are discounted at 10%?
NPV = -$10,000 - $7,272.73 - $4,132.23 + $11,269.72 + $17,075.34
= $ 6,940.10
NPV $10,
$8,
.
$5,
.
$15,
.
$25,
.
000
000
11
000
11
000
11
000
11
2 3 4
IRR and NPV
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1 P/ YR
10,000 +/-
+/-
+/-
8,000
CFj
CFj
CFj
CFj
CFj
5,000
15,000
25,000
10 I/ YR
NPV
Clear registers
One payment per year
Initial CF = - $ 10,000
1st CF = - $ 8,000
2nd CF = - $ 5,000
3rd CF = $ 15,000
4th CF = $ 25,000
Discount rate = 10%
Compute net present value
IRR and NPV
Example: IRR for grouped cash flows.
Compute the IRR for an investment that costs $92,725.60
today and is expected to pay $10,000 at the end of the year for
the next three years; $15,000 at the end of years 4 and 5; and
$100,000 at the end of year 6.
d = 12%
$92, .
$10,
( )
$15,
( )
$100,
( )
725 60
000
1
000
1
000
1
1
3
4
5
6

d d d
t
t
t
t
IRR and NPV
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1 P/ YR
92,725.60+/- CFj
CFj
CFj
10,000
3
15,000
2
100,000 CFj
IRR/ YR
N j
N j
Clears registers
One payment per year
Initial CF = - $ 92,725.60
1st grouped CF = $ 10,000
Occurs three times
2nd grouped CF = $ 15,000
Occurs twice
3rd CF = $ 100,000 (once)
Compute the yield (IRR)
IRR and NPV
Example: NPV for grouped cash flows.
Compute the NPV for an investment that costs $98,000 today and is
expected to pay $791.38 at the end of each month for 12 months; $850.73 at
the end of each month for the following 12 months; $914.54 at the end of
each month for the following 11 months and a balloon payment of
$107,491.18 at the end of month 36 if the investor discounts future cash
flows monthly at a 13% annual rate.
NPV = - $554.17 = - $98,000 +
$791.
(
.
)
$850.
(
.
)
$914.
(
.
)
$107, .
(
.
)
38
1
1
013
12
73
1
1
013
12
54
1
1
013
12
49118
1
013
12
1
12
13
24
25
35
36

t
t
t
t
t
t
IRR and NPV
HP 10B Keystrokes
CLEAR ALL
12 P/ YR
98,000 +/- CFj
CFj
CFj
CFj
CFj
I/ YR
NPV
791.38
12
850.73
12
914.54
11
107,491.18
13
N j
N j
N j
Clear registers
Monthly payments
Initial CF = - $98,000
1st grouped CF = $791.38
Occurs 12 times
2nd grouped CF = $850.73
Occurs 12 times
3rd grouped CF = $914.54
Occurs 11 times
4th CF = $107,491.18 (once)
Discount rate = 13%
Compute net present value