A B C D E F G H

16
17 Figure 10-1

18 Cash Flows and Selected Evaluation Measures for Projects S and L (Millions of Dollars)

19 Panel A: Inputs for Project Cash Flows and Cost of Capital, r

20
21 INPUTS:
22 r = 10%
23 Initial Cost and Expected Cash Flows
24 Year 0 1 2 3 4
25 Project S −$10,000 $5,300 $4,300 $1,874 $1,500
26 Project L −$10,000 $1,900 $2,700 $2,345 $7,800
27
28 Panel B: Summary of Selected Evaluation Measures
29 Project S Project L
30 Net present value, NPV $804.38 $1,048.02
31 Internal rate of return, IRR 14.69% 13.79%
32 Modified IRR, MIRR 12.15% 10.19%
33 Profitability index, PI 1.08 1.10
34 Payback 2.21 3.39
35 Discounted payback 3.21 3.80
36
37
38
39 10-3 Net Present Value (NPV)
40
41 To calculate the NPV, we find th e p resent value of th e individu al cash flow s and then sum those d iscounted cash flow s. Th e sum is
42 the value the project ad ds to or subtracts from sharehold er w ealth.
43
44 Figure 10-2
45 Finding the NPV for Projects S and L (Millions of Dollars)
46 INPUTS:
47 r = 10%
48 Initial Cost and Expected Cash Flows
49 Year 0 1 2 3 4
50 Project S −$10,000 $5,300 $4,300 $1,874 $1,500
51 4,818.18 ←←⤶ ↓ ↓ ↓
52 3,553.72 ←←←← ←← ←←⤶ ↓ ↓
53 1,407.96 ←←←← ←← ←←←← ←← ←←⤶ ↓
54 1,024.52 ←←←← ←← ←←←← ←← ←←←← ←← ←←⤶
55 NPVS = $804.38 Long way:
56 Sum the PVs of th e CFs to find NPV
57 Initial Cost and Expected Cash Flows
58 Year 0 1 2 3 4
59 Project L −$10,000 $1,900 $2,700 $2,345 $7,800
60 NPVL = $1,048.02
Short way: Use Exce l's NPV fu nction
61 = NPV(B47,C59 :F59)+B5 9
62
63
64 10-4 Internal Rate of Return (IRR)
65
66 The internal rate of retu rn is d efined as the discount rate that equates the present value of a project's cash inflows to its outflows.
67 In other words, the internal rate of retu rn is the interest rate that forces NPV to zero. The calculation for IRR can be tediou s, but
68 Excel p rovides an IRR fu nction that merely requ ires you to access the function and enter the array of cash flows. The IRRs for
Project S and L are show n below, along with the data entry for Project S.
69
70
71 Figure 10-3
72 Finding the IRR for Projects S and L (Millions of Dollars)
73 INPUTS:
74 Initial Cost and Expected Cash Flows
75 Year 0 1 2 3 4
76 Project S −$10,000 $5,300 $4,300 $1,874 $1,500
77 4,621.33 ←←⤶ ↓ ↓ ↓
78 3,269.26 ←←←← ←← ←←⤶ ↓ ↓
79 1,242.34 ←←←← ←← ←←←← ← ←← ⤶ ↓
80 867.07 ←←←← ←← ←←←← ← ←←←← ← ←←⤶
81
82 Long way: Try a value for r, sum the PVs of the CFs to find
NPVS = $0.00 NPV. If NPV is not zero, try another valu e for r. O r use Goal
83 Seek to find the value of r that makes the NPV = 0.

84 IRR = r = 14.69% Value of r that makes NPV = 0.

85
86 Initial Cost and Expected Cash Flows
87 Year 0 1 2 3 4
88 Project L −$10,000 $1,900 $2,700 $2,345 $7,800
89 IRR L = 13.79% Short way: Use Excel's IRR function =IRR( B8 8:F88)
90
91
92
93
The IRR m ethod of capital b udgeting maintains that projects sh ou ld be accep ted if their IRR is greater than the cost of capital.
94 Strict adherence to the IRR method would further d ictate that m utually exclusive p rojects should be chosen on th e basis of the
95 greater IRR. In our exam ple, each project has an IRR th at exceeds the cost of cap ital (10%) so both projects should be accepted if
96 they are independent. If, h owever, the projects are m utually exclusive, we wou ld ch oose Project S because it has the higher IRR.
Recall that th is differs from ou r conclusion when u sing the NPV meth od. So, we h ave a conflict b etween th e NPV and the IRR
97 methods for ranking Projects S and L.
98
99
100
101 A Potential Problem with IRR: The Possibility of Multiple IRRs
102
103
104 Because of th e m athematics involved, it is possible for some (b ut not all) projects that have m ore than one change of signs in the
cash flows to have more than one IRR. If you attempted to find th e IRR w ith such a project u sing a financial calcu lator, you would
105 get an error m essage. The HP-10B says "Error - Soln", the HP-17B says '"Many/No Solutions, and the HP12C says Error 3; K ey in
106 Guess." Th e p rocedure for correcting the problem is to store in a guess for th e IRR, and then the calculator will rep ort th e IRR that
is closest to you r guess. You can then use a different "guess" valu e, and you sh ould be able to find the oth er IRR. How ever, th e
107 nature of the mathem atics creates a scenario in which one IRR is quite extraordinary (often, several hu ndred percent).
108
109
110 Suppose Project M has the following cash flows:
111
112 INPUTS:
113 Year 0 1 2
114 Project M -1.60 10 -10
115
116
117
118
The table show n below calcu lates Project M's NPV at the rates (i.e., cost of capital) show n in the left colu mn. Notice th at NPV = 0 at
119 both 2 5% and 400%. Since the definition of th e IRR is th e rate at wh ich the NPV = 0, there are two IRRs.
120
121
122 r NPV
123 0% -$1.600
124 10% -$0.774
125 15% -$0.466
126 20% -$0.211
127 25% $0.000 = IRR #1 = 25%
128 30% $0.175
129 40% $0.441
130 50% $0.622
131 60% $0.744
132 70% $0.822
133 80% $0.869
134 90% $0.893
135 95% $0.898
136 97% $0.899
137 98% $0.900
138 99% $0.900
139 100% $0.900
140 101% $0.900
141 102% $0.900
142 103% $0.899
143 102% $0.900
144 105% $0.899
145 110% $0.894
146 120% $0.879
147 160% $0.767
148 200% $0.622
149 300% $0.275
150 400% $0.000 = IRR #2 = 400%
151 500% -$0.211
152
153
154
155 Figure 10-4
156 Graph for Multiple IRRs: Project M (Millions of Dollars)
157
158
159 NPV
160 (Millions )
$ NPV = −$1.6 + $10/(1+r) + (−$10)/(1+r)2
161
162 $

163 $
164 IRR #2 = 400%
165 $
166 0% 50%
167 -$
168
169 -$ Cost of Capital, r (%)
170
171 -$ IRR #1 = 25%
172
173 -$
174
175
176
177 A Potential Problems When Using the IRR to Evaluate Mutually Exclusive Projects
178
179 The IRR and NPV can leading to conflicting decisions when choosing among mutually exclusive projects.
180
181 NPV IRR
182 Project S $804.38 14.69%
183 Project L $1,048.02 13.79%
184
185
186 An NPV profile sh ow s how a project's NPV declines as r (the cost of capital used to calculate the NPV) increases. The crossover
187 rate is the rate at which the NPV of Project S is eq ual to the NPV of Project L. The easiest way to find the crossover rate is to
subtract one p roject's cash flows from the others and find the IRR of th is differential cash flow stream.
188
189
190
191 Year 0 1 2 3 4
192 Project S -$10,000 $5,300 $4,300 $1,874 $1,500
193 Project L -10,000 1,900 2,700 2,345 7,800
194 Δ = CF S − CFL $0 $3,400 $1,600 -$471 -$6,300
195
196 IRR Δ = 12.274%
197
198
199 NPV Profiles for Projects S and L
200
201 Cost of Capital NPV S NPV L
202 0% $2,974.00 $4,745.00
203 5% 1,800.73 2,701.28
204 10% 804.38 1,048.02
205 Crossover = 12.274% 399.91 399.91 N PVS = NPVL
206 IRR L = 13.786% 145.90 0.00 N PVL = 0
207 IRR S = 14.686% 0.00 -227.16 N PVS = 0
208 20% -$789.35 -$1,423.03
209
210
211
212
213 Figure 10-5
214 NPV Profiles for Projects S and L (Millions of Dollars)
215
216
217
218 5,000 NPV ($)
219 L Crossover: Conflict if WACC is to left of
220 crossover; no conflict if WACC is to right.
221 Since WACC = 10%, which is left of the
222 4,000 crossover rate, there IS a conflict: NPVL >
223 NPV S, but IRR S > IRRL.
224 At 10% WACC:
225 NPVL
226 3,000 S
227
228
229
230 2,000
231
232
233
234 1,000
235 At 10% WACC: IRRS
236 NPV S
237
238 0
239 0% 10% 20% 30%
240
241 Cost of Capital
242 -1,000 IRR L
243
244
245
246 -2,000
247
248
249
250 Crossovers are caused by timing differences and size differences as shown below.
251
252
Project Sooner has a higher proportion of its future cash flows occu rring sooner than the proportion for Project Later. Notice that
253 Sooner has a higher IRR but a low er NPV.
254
255
256 r = 10%
257 Year
258 Project 0 1 2 NPV IRR
259 Sooner −$1,000 $1,020 $120 $26 12.7%
260 Later −$1,000 $120 $1,120 $35 12.0%
261 Δ = CF S − CFL $0 $900 −$1,000 11.1%
262
263
264 Both projects have half of their fu tu re cash flows occurring each year, but Project Smaller has a smaller scale th at Project Larger.
265 Notice that Smaller has a higher IRR bu t a lower NPV.
266
267 r = 10%
268 Year
269 Project 0 1 2 NPV IRR
270 Smaller −$90 $12 $112 $13 18.4%
271 Larger −$1,000 $120 $1,120 $35 12.0%
272 Δ = CF S − CFL $910 −$108 −$1,008 11.3%
273
274
275 10-5 Modified Internal Rate of Return (MIRR)
276
277 The modified internal rate of return is the discount rate that causes a project's cost (or cash ou tflows) to equ al the present value
278 of the project's terminal value. Th e term inal value is defined as the sum of th e future values of the project's cash inflow s,
279 compou nded at the project's cost of capital. To find MIRR, calcu late the PV of the outflows and the FV of the inflows, and th en find
the rate that equates the two. Alternatively, you can solve using Excel's MIRR fu nction.
280
281
282 Also, note that Excel's MIRR function allows for discounting and reinvestm ent to occu r at different rates. Generally, MIRR is
283 defined as reinvestment at the WACC, though Excel allows the calculation of MIRR where reinvestment is likely to occur at a
284 different rate than WACC.
285
286
If negative cash flows occu r in years beyond Year 1, those cash flow s should be discounted at the cost of capital and ad ded to the
287 Year 0 cost to find the total PV of costs. If both p ositive and negative flows occu rred in a given year, the negative flows shou ld b e
discou nted, and the positive ones compound ed, rath er than just dealing with the net cash flow. This can m ake a difference.
288
289
290
291 Figure 10-6
292 Finding the MIRR for Projects S and L
293 INPUTS:
294 r = 10%
295 Initial Cost and Expected Cash Flows
296 Year 0 1 2 3 4
297 Project S −$10,000 $5,300 $4,300 $1,874 $1,500
298 ↓ ↓ ↓ ⤷ →→ $2,061
299 ↓ ↓ ⤷→ → →→→→→ $5,203
300 Present Valu e of ↓ ⤷→ → →→→→→ →→→→→ $7,054
301 Negative CF (PV) = −$10,000 Terminal Value of Positive CF (TV) = $15,819
302
303 Calculator: N = 4, PV = −10000, PMT = 0, FV = 15819. Press I/YR to get: MIRR S = 12.15%
304 Excel Rate function–Easier: =RATE(F296 ,0,B3 01,F301) MIRR S = 12.15%
305 Excel MIRR fu nction–Easiest: =MIRR(B29 7:F297 ,B294,B29 4) MIRR S = 12.15%
306
307 Year 0 1 2 3 4
308 Project L −$10,000 $1,900 $2,700 $2,345 $7,800
309
310 For Project L, using the MIRR function: =MIRR( B308:F3 08,B294,B294) MIRR L = 12.78%
311
312 Notes:
313 1. The terminal value (TV) is the future value of all p ositive cash flow s. The present value (PV) is the present value of
314 all negative cash flows.
315
316 2. Find the discount rate th at forces the TV positive cash flows to equal the PV of negative cash flows. Th at d iscount
rate is d efined as the MIRR.
317 PV of negative cash flows =(TV of p ositive cash flow s)/(1+MIRR) N
318 $10,000 = $1 5,819/(1+MIRR) 4
319 We can find the MIRR with a calculator or Excel.
320
321
322
323 10-6 Profitability Index (PI)
324
325
326 The profitability index is the present value of all future cash flows divided by the initial cost. It measures the PV per dollar of investment.
327
328
329 Figure 10-7
330 Profitability Index (PI)
331
332 Project S: PI S = PV of future cash flows ÷ Initial cost
333 PI S = $10,804 ÷ $10,000
334 PI S = 1.0804
335
336 Project L: PI L = PV of future cash flows ÷ Initial cost
337 PI L = $11,048 ÷ $10,000
338 PI L = 1.1048
339 Notes:
340
341 1. If Projects L and S are ind ependent, both should be accepted as both have PI greater
than 1.0. However, if they are m utually exclusive, Project L should be chosen as it has the
342 higher PI.
343
2. PI and NPV rank ings will be consistent if th e p rojects have the same cost, as is true for S
344 and L. However, if they differ in size, conflicts can occur. In the event of a conflict, th e NPV
345 ranking should be used.
346
347 10-7 Payback Period
348
349
The payback period is defined as the expected number of years requ ired to recover the investment, and it was the first formal
350 method u sed to evaluate capital budgeting projects. First, we identify the year in w hich the cumulative cash inflow s exceed the
initial cash outflows. Th at is the payback year. Then w e take the previous year and add to it the unrecovered balance at th e end of
351 that year d ivided by the follow ing year's cash flow. Generally speaking, the sh orter the payback period, the better the investment.
352
353
354 It's easy to calculate the payb ack manually--calculate cumulative cash flows and look to see when the cum ulative CF turns
355 positive, and recognize that the payback year is the prior year plus a fraction equal to the shortfall divided by the CF in th e next
356 year. However, it would be useful to have an automated p rocedure if you were calculating many paybacks or if you w anted to do
357 sensitivity analysis for a given project, but th is is m ore comp licated. You can see the formula b elow , and the procedu re is
explained in d etail in our Excel Tutorial. We u se the formu la only if we m ust do a nu mber of p ayback calcu lations--for just one or
358 two, the manual approach is much easier.
359
360
361
362 Figure 10-8
363 Payback Period
364
365 Project S Year 0 1 2 3 4
366 Cash flow −$10,000 $5,300 $4,300 $1,874 $1,500
367 Cumulative cash flow −$10,000 −$4,700 −$400 $1,474 $2,974
368 Intermediate calculation for payback — — — 2.21 3.98
369 ↑
370 Intermediate calculation:
371 Manual calculation of Payback S = 2 + $400/$1,874 = 2.21 =IF(F367>0,E365+ABS(E367/F366),"—")
372 Excel calcu lation of Payback S = 2.21 2.21
373
374 Project L Year 0 1 2 3 4
375 Cash flow −$10,000 $1,900 $2,700 $2,345 $7,800
376 Cumulative cash flow −$10,000 −$8,100 −$5,400 −$3,055 $4,745
377
378 Manual calculation of Payback L = 3 + $3,055/$7,800 = 3.39 Payback switch es from
negative to positive cash
379 Alternative Excel calculation of Payback L = flow.
380 =PERCENTRANK(C376 :G376,0,6 )*G37 4 = 3.39
381
382
383
384 The regu lar payback has two m ajor flaws. First, it does not take accou nt of any cash flows that occur p ast the payback year, no
385 matter how large those flows m igh t be. Second , th e p ayback does not take account of the time value of money. This second
386 problem is ad dressed with the discounted payback as discu ssed below, bu t the failure to consider beyond -payback cash flows is a
problem for both p ayback meth od s.
387
388
389
390 Figure 10-9
391 Discounted Payback
392
393 Project r = 10%
394 Project S Year 0 1 2 3 4
395 Cash flow −$10,000 $5,300 $4,300 $1,874 $1,500
396 Discounted cash flow −$10,000 $4,818 $3,554 $1,408 $1,025
397 Cumulative discounted CF −$10,000 −$5,182 −$1,628 −$220 $804
398
399 Discounted Payback S = 3 + $220.14/$1,024.52 = 3.21 Switches from negative to
400 Excel calculation of Discounted Payback S = positive cash flow.
401 = PERCENTRANK( C397:G3 97,0,6)*G394 3.21
402
403 Project L Year 0 1 2 3 4
404 Cash flow −$10,000 $1,900 $2,700 $2,345 $7,800
405 Discounted cash flow −$10,000 $1,727 $2,231 $1,762 $5,328
406 Cumulative discounted CF −$10,000 −$8,273 −$6,041 −$4,279 $1,048
407
408 Discounted Payback L = 3 + $4,279.49/$5,327.50 = 3.80 Switches from negative to
409 Excel calculation of Discounted Payback L = positive cash flow.
410 = PERCENTRANK( C406:G4 06,0,6)*G403 3.80
411
412
413
414
415 10-8 How to Use the Different Capital Budgeting Methods
416
417 NPV is the single b est criterion because it provides a direct m easu re of the value a project ad ds to sharehold er w ealth. How ever,
418 all m ethods provid e h elp ful inform ation.
419
420 NPV and IRR are the most widely used methods.
421
 12/8/2012
Web Extension 10A: The Accounting Rate of Return

ACCOUNTING RATE OF RETURN (ARR)

The ARR is the second oldest criterion, after the regular payback. We have seen several versions
of the ARR, but the one we've seen most often is shown below. In the example we assume that the
projects both have $2,500 of depreciation per year.

Average annual cash inflows – Average annual depreciation

ARR =
Average Investment

Project S Project L
Average CF $3,244 $3,686.25
Average Depreciation $2,500 $2,500
Years 4 4
Investment $10,000 $10,000
Avg. Investment $5,000 $5,000
$744
ARRS = = 14.87%
$5,000

$1,186.25
ARRL = = 23.73%
$5,000

We don't like the ARR, primarily because it ignores the time value of money and also because the
IRR and the MIRR provide much more reasonable rate of return estimates. We include it here
strictly for completeness.
SECTION 10-3
SOLUTIONS TO SELF-TEST

Projects SS and LL have the following cash flows:

WACC = r = 10%
0 1 2 3
SS -700 500 300 100
LL -700 100 300 600

If a 10% cost of capital is appropriate for both of them, what are their NPVs?

NPV
SS $77.61
LL $89.63

What project or set of projects would be in your capital budget if SS and LL

were (a) independent or (b) mutually exclusive?

If the projects are independent, accept both. If the projects are mutually exclusive, accept Project LL.
SECTION 10-4
SOLUTIONS TO SELF-TEST

The cash flows for Projects SS and LL are as follows:

WACC = r = 10%
0 1 2 3
SS -700 500 300 100
LL -700 100 300 600

What are the two projects’ IRRs, and which one would the IRR method
select if the firm has a 10% cost of capital and the projects are
(a) independent or (b) mutually exclusive?

IRR
SS 18.0%
LL 15.6%

If the two projects are independent, accept both. If the two projects are mutually exclusive,
accept Project LL.

Project MM has the following cash flows:

r= 10%

0 1 2 3
-$1,000 $2,000 $2,000 -$3,350

Calculate MM’s NPV at discount rates of 0%, 10%, 12.2258%, 25%,

122.1470%, and 150%. What are MM's IRRs? If the cost of capital were
10%, should the project be accepted or rejected?

NPV = -$45.83

WACC: -$45.83
0%
10%
12.2258%
25%
122.1470%
150%

$12

$10

$8

$6

$4

$2

$0
0% 20% 40% 60% 80% 100% 120% 140% 160%
$10

$8

$6

$4

$2

$0
0% 20% 40% 60% 80% 100% 120% 140% 160%
 Multiple IRRs: Projec t MM

SECTION 10-5
SOLUTIONS TO SELF-TEST

Projects A and B have the following cash flows:

0 1 2
A -$1,000 $1,150 $100
B -$1,000 $100 $1,300

Their cost of capital is 10%. What are the projects’ IRRs, MIRRs, and NPVs?
Which project would each method select?

WACC = 10%
IRR MIRR NPV
A 23.1% 16.8% $128.10
B 19.1% 18.7% $165.29

We used Excel functions to calculate these values. See the Tutorial for instructions on
the NPV, IRR, and MIRR functions.
SECTION 10-6
SOLUTIONS TO SELF-TEST
A project has the following expected cash flows: CF0 = -$500, CF1 =
$200, CF2 = $200, and CF3 = $400. If the project's cost of capital is
9%, what is the PI?
WACC = r 9%

0 1 2 3
-$500 $200 $200 $400

PI = PV of future cash flows ¸ Initial cost

$660.70 ¸ $500
PI = 1.32139
SECTION 10-7
SOLUTIONS TO SELF-TEST

Project P has a cost of $1,000 and cash flows of $300 per year for 3
years plus another $1,000 in Year 4. The project’s cost of capital is
15%. What are P’s regular and discounted paybacks?

Regular payback
Years 0 1 2 3 4
| | | | |
Cash Flow -1,000 300 300 300 1,000
Cumulative Cash Flow -1,000 -700 -400 -100 900

Regular payback = 3.10

Discounted payback
WACC 15%
Years 0 1 2 3 4
| | | | |
Cash Flow -1,000 300 300 300 1,000
Discounted Cash Flow -1,000 261 227 197 572
Cumulative Discounted CF -1,000 -739 -512 -315 257

Discounted payback = 3.55

If the company requires a payback of 3 years or less, would the

project be accepted?

The payback rule of 3 years leads to a reject decision.

Would this be a good accept/reject decision, considering the NPV

and/or the IRR?

NPV = $256.72
IRR = 24.78%

The payback rule conflicts with both the NPV and IRR criteria, which
would suggest accepting the project.