A B C D E F G H

12
13 In this file we use Excel to do most of the calculations explained in the textbook. First, we analyze Projects S and L,
14 whose cash flows are shown immediately below in time line formats. Spreadsheet analyses can be set up vertically, in
a table with columns, or horizontally, using time lines. For short problems, with just a few years, we generally use
15
the time line format because rows can be added and we can set the problem up as a series of income statements. For
16 long problems, it is often more convenient to use a vertical layout.
17
18
19
20
21 Figure 10-1. Net Cash Flows (CFt) and Selected Evaluation Criteria for Projects S and L
22
23 Panel A: Project Cash Flows and Cost of Capital
24
25 Project cost of capital, r, for each project: 10%
26
27 Initial Cost After-Tax, End of Year, Project Cash Flows, CF t
28 0 1 2 3 4
29 Project S -$10,000 $5,000 $4,000 $3,000 $1,000
30 Project L -$10,000 $1,000 $3,000 $4,000 $6,750
31
32 Panel B: Summary of Selected Evaluation Criteria
33
34 Project S Project L
35 NPV $788.20 $1,004.03
36 IRR 14.49% 13.55%
37 MIRR 12.11% 12.66%
38 PI 1.08 1.10
39 Payback 3.30
40 Discounted Payback 2.95 3.78
41
42
43
44
45
46 Figure 10-2. Finding the NPV for Projects S and L
47
48 To calculate the NPV, we find the present value of the individual cash flows and then sum those discounted cash
49 flows. The sum is the value the project adds to or subtracts from shareholder wealth.
50
51 r = 10%
52
53 Year = 0 (r = 10%) 1 2 3 4
54 Project S -10,000.00 5,000 4,000 3,000 1,000
55 4,545.45
56 3,305.79
57 2,253.94
58 683.01
59 NPVS = $788.20 Long way: Sum the PVs of the CFs to find NPV
60
61 Year = 0 (r = 10%) 1 2 3 4
 A B C D E F G H
62 Project L -10,000.00 1,000 3,000 4,000 6,750
63
64 NPVL = $1,004.03 Short way: Use Excel's NPV function =NPV(B51,C62:F62)+B62
65
66
67
The NPV criterion says that all independent projects that have positive NPV should accepted. The rationale for this
68 is that all such projects add wealth, and that should be the overall goal of the manager in all respects. If strictly
69 using the NPV method to evaluate two mutually exclusive projects, you would want to accept the project that adds
70 the most value (i.e. the project with the higher positive NPV). Hence, if considering the above two projects, you
71 would accept both projects if they are independent, and you would only accept Project L if they are mutually
72 exclusive.
73
74
75 INTERNAL RATE OF RETURN (IRR) (Section 10.3)
76
77
78 The internal rate of return is defined as the discount rate that equates the present value of a project's cash inflows to
79 its outflows. In other words, the internal rate of return is the interest rate that forces NPV to zero. The calculation
80 for IRR can be tedious, but Excel provides an IRR function that merely requires you to access the function and
81 enter the array of cash flows. The IRRs for Project S and L are shown below, along with the data entry for Project S.
82
83
84
85
86 Figure 10-3. Finding the IRR
87
88 r = 14.49%
89 Year = 0 1 2 3 4
90 Project S -10,000.00 5,000 4,000 3,000 1,000
91 4,367.24
92 3,051.64
93 1,999.09
94 582.03
95 Sum of PVs = $0.00 = NPV at r = 14.489%. NPV = 0, so IRR = 14.489%.
96
97 IRRS = 14.49% =IRR(B90:F90) using IRR function
98
99 Year = 0 1 2 3 4
100 Project L -10,000.00 1,000 3,000 4,000 6,750
101
102 IRRL = 13.55% =IRR(B100:F100) using IRR function
103
104
105 The IRR method of capital budgeting maintains that projects should be accepted if their IRR is greater than the cost of capital.
106 Strict adherence to the IRR method would further dictate that mutually exclusive projects should be chosen on the basis of the
107 greater IRR. In our example, each project has an IRR that exceeds the cost of capital (10%) so both projects should be accepted
108 if they are independent. If, however, the projects are mutually exclusive, we would choose Project S because it has the higher
109 IRR. Recall that this differs from our conclusion when using the NPV method. So, we have a conflict between the NPV and the
110 IRR methods for ranking Projects S and L.
111
112
113 MULTIPLE IRRS (Section 10.4)
 A B C D E F G H
115 Because of the mathematics involved, it is possible for some (but not all) projects that have more than one change of signs in the
116 cash flows to have more than one IRR. If you attempted to find the IRR with such a project using a financial calculator, you
117 would get an error message. The HP-10B says "Error - Soln", the HP-17B says '"Many/No Solutions, and the HP12C says Error
118 3; Key in Guess." The procedure for correcting the problem is to store in a guess for the IRR, and then the calculator will report
119 the IRR that is closest to your guess. You can then use a different "guess" value, and you should be able to find the other IRR.
120 However, the nature of the mathematics creates a scenario in which one IRR is quite extraordinary (often, several hundred
121 percent).
122
123
124 Figure 10-4. Graph for Multiple IRRs: Project M (Millions of Dollars)
125
126
127 Year = 0 1 2
128 Project M -1.60 10 -10
129
130 r = 10% NPV = -$0.774
131
132 NPV
133 (Millions)
134
135 $0.90 NPV = −$1.6 + $10/(1+r) + (−$10)/(1+r)2
136
137 $0.70
138
139
$0.50
140
141
142 $0.30
143 IRR #1 = 25% IRR #2 = 400%
144
$0.10
145
146
147 -$0.10 0% 50% 100% 150% 200% 250% 300% 350% 400% 450% 500%
148
149
-$0.30
150
Cost of Capital (%)
151
152
153 Note:
154 The table shown below calculates Project M's NPV at the rates shown in the left column. These data are plotted to
155 form the graph shown above. Notice that NPV = 0 at both 25% and 400%. Since the definition of the IRR is the rate
156 at which the NPV = 0, there are two IRRs.
157
158 r NPV
159
160 0% -$1.600
161 10% -$0.774
162 25% $0.000 = IRR #1 = 25%
163 110% $0.894
164 400% $0.000 = IRR #2 = 400%
165 500% -$0.211
166
167
168
 A B C D E F G H
169 REINVESTMENT RATE ASSUMPTIONS (Section 10.5)
170
171
172 The IRR approach assumes that cash flows can be reinvested at the IRR, but it is more realistic to asssume that cash
flows only can be reinvested at the cost of capital. For this reason, NPV is a better decision criterion than IRR.
173
174
175 MODIFIED INTERNAL RATE OF RETURN, MIRR (Section 10.6)
176
177 The modified internal rate of return is the discount rate that causes a project's cost (or cash outflows) to equal the
178 present value of the project's terminal value. The terminal value is defined as the sum of the future values of the
179 project's cash inflows, compounded at the project's cost of capital. To find MIRR, calculate the PV of the outflows
180 and the FV of the inflows, and then find the rate that equates the two. Alternatively, you can solve using Excel's
181 MIRR function.
182
183 One advantage of using the MIRR, relative to the IRR, is that the MIRR assumes that cash flows received are
184 reinvested at the cost of capital, not the IRR. Since reinvestment at the cost of capital is more likely, the MIRR is a
185 better indicator of a project's profitability. Moreover, it solves the multiple IRR problem, as a set of cash flows can
186 have but one MIRR.
187
188 Also, note that Excel's MIRR function allows for discounting and reinvestment to occur at different rates. Generally,
189 MIRR is defined as reinvestment at the WACC, though Excel allows the calculation of MIRR where reinvestment is
190 likely to occur at a different rate than WACC.
191
192
193 As is stated in the text, NPV is superior to the IRR because (1) the NPV assumes that cash flows are reinvested at the
cost of capital whereas the IRR assumes reinvestment at the IRR, and (2) it is more likely, in a competitive world,
194
that the actual reinvestment rate will be the cost of capital than the IRR, especially if the IRR is quite high. The
195 MIRR setup can be used to prove that NPV indeed does assume reinvestment at the WACC and IRR at the IRR.
196
197
198 If negative cash flows occur in years beyond Year 1, those cash flows should be discounted at the cost of capital and
199 added to the Year 0 cost to find the total PV of costs. If both positive and negative flows occurred in a given year,
200 the negative flows should be discounted, and the positive ones compounded, rather than just dealing with the net
201 cash flow. This can make a difference.
202
203
204 Figure 10-5. Finding the MIRR for Projects S and L
205
206 r= 10%
207
208 Year = 0 (r = 10%) 1 2 3 4
209 Project S -10,000 5,000 4,000 3,000 1,000
210 $3,300
211 $4,840
212 $6,655
213 -10,000 Terminal Value (TV) = $15,795
214
215 Calculator: N = 4, PV = -10000, PMT = 0, FV = 15795. Press I/YR to get: MIRRS = 12.11%
216 Excel Rate function--Easier: =RATE(F208,0,B209,F213) MIRRS = 12.11%
217 Excel MIRR function--Easiest: =MIRR(B209:F209,B206,B206) MIRRS = 12.11%
218
219 Year = 0 (r = 10%) 1 2 3 4
 A B C D E F G H
220 Project L -10,000 1,000 3,000 4,000 6,750
221
222 For Project L, using the MIRR function: =MIRR(B220:F220,B206,B206) = MIRRL = 12.66%
223
224 Notes:
225 1. In Figure 10-5 we find the discount rate that forces the present value of the terminal
226 value to equal the project's cost. That discount rate is defined as the MIRR.
227 $10,000 =TV/(1+MIRR)N = $15,795/(1+MIRR)4 . We can find the MIRR with a
228 calculator or Excel.
229 2. If S and L are independent, both should be accepted as both MIRRs exceed the cost of capital. If
230 they are mutually exclusive, then L should be chosen because it has the higher MIRR.
231
232
233
234 NPV PROFILES (Section 10.7)
235
236 An NPV profile shows how a project's NPV declines as the WACC used to calculate the NPV increases. Figure 10-4,
237 for the multiple IRR example, shows a NPV profile. Normally, though, the cash flows change sign only once--a
238 negative for the Time = 0 cash flow and then positive cash flows thereafter, so normally NPV profiles look like the
239 one in Figure 10-6.
240
241
242 Figure 10-6. NPV Profile for Project S
243
244 Cost of capital = 10.00%
245 Year = 0 1 2 3 4
246 Project S -10,000.00 5,000 4,000 3,000 1,000
247
248 r NPVS
249 0% $3,000.00
250 5% 1,804.24
251 10% 788.20
252 14.489% 0.00 NPV = $0, so IRR = 14.489%
253 15% -83.30
254 20% -837.19
255
256
257 Net Present Value for S PROJECT S's NPV PROFILE
258
259
260
261
262
263 $2,000
264
NPVS = 0, so IRR = 14.489%
265
266
267
268
269
270
271
272
273 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%
274
Cost of Capital (%)
-$1,000
 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%
A B C D E F G H
275 Cost of Capital (%)
276 -$1,000
277
278
279
280
281
282 The Crossover Rate
283
284 The crossover rate is the rate at which the NPV of Project S is equal to the NPV of Project L. The easiest way to find
285 the crossover rate is to subtract one project's cash flows from the others and find the IRR of this differential cash
286 flow stream.
287
288
289 Year = 0 1 2 3 4
290 Project S -$10,000 $5,000 $4,000 $3,000 $1,000
291 Project L -10,000 1,000 3,000 4,000 6,750
292 D = CFS − CFL $0 $4,000 $1,000 -$1,000 -$5,750
293
294 IRR D = 11.975%
295
296
 A B C D E F G H
297 Figure 10-7. NPV Profiles for Projects S and L: Shows Why Conflict Occurs
298
299 Cost of Capital NPVS NPVL
300 0% $3,000.00 $4,750.00
301 5% 1,804.24 2,682.06
302 10% 788.20 1,004.03
303 Crossover = 11.975% 428.38 428.38 NPVS = NPVL
304 IRRL = 13.549% 156.40 0.00 NPVL = 0
305 IRRS = 14.489% 0.00 -243.65 NPVS = 0
306 20% -$837.19 -$1,513.31
307
308 $5,000 NPV
309
310
L
311 Crossover: Conflict if WACC is to
312 left of crossover, no conflict if
$4,000
313 WACC is to right. Since WACC =
314 10%, which is left of the crossover
315 rate, there IS a conflict: NPVL >
316 S NPVS, but IRRS > IRRL.
$3,000
317
318 At WACC:
319 NPVL > NPVS
320
$2,000
321
322
323
324
$1,000
325
326 IRRS > IRRL
327 NPVS at WACC
328
$0
329
0% 10% 20% Cost of Capital 30%
330
331
332 IRRL
333 -$1,000
334
335
336
337 -$2,000
338
339
340
341
342 PROFITABILITY INDEX (PI) (Section 10.8)
343
344 The profitability index is the present value of all future cash flows divided by the intial cost. It measures the PV per
345 dollar of investment.
346
347
348
349 Figure 10-8. Profitability Index (PI)
350
351 Project S: PIS = PV of future cash flows ÷ Initial cost
352 PIS = $10,788.20 ÷ $10,000
 A B C D E F G H
353 PIS = 1.0788
354
355 Project L: PIL = PV of future cash flows ÷ Initial cost
356 PIL = $11,004.03 ÷ $10,000
357 PIL = 1.1004
358 Notes:
359 1. If Projects L and S are independent, both should be accepted as both have PI greater than 1.0.
360 However, if they are mutually exclusive, Project L should be chosen as it has the higher PI.
361 2. PI and NPV rankings will be consistent if the projects have the same cost, as is true for S and L.
362 However, if they differ in size, conflicts can occur. In the event of a conflict, the NPV ranking
363 should be used.
364
365
366 PAYBACK PERIOD (Section 10.9)
367
368
369 The payback period is defined as the expected number of years required to recover the investment, and it was the
370 first formal method used to evaluate capital budgeting projects. First, we identify the year in which the cumulative
cash inflows exceed the initial cash outflows. That is the payback year. Then we take the previous year and add to it
371
the unrecovered balance at the end of that year divided by the following year's cash flow. Generally speaking, the
372 shorter the payback period, the better the investment.
373
374
375
376 It's easy to calculate the payback manually--calculate cumulative cash flows and look to see when the cumulative
377 CF turns positive, and recognize that the payback year is the prior year plus a fraction equal to the shortfall divided
by the CF in the next year. However, it would be useful to have an automated procedure if you were calculating
378
many paybacks or if you wanted to do sensitivity analysis for a given project, but this is more complicated. You can
379 see the formula below, and the procedure is explained in detail in our Excel Tutorial. We use the formula only if we
380 must do a number of payback calculations--for just one or two, the manual approach is much easier.
381
382
383
 A B C D E F G H
384 Figure 10-9. Payback Period
385
386 Years = 0 1 2 3 4
387 Project S Cash flow -10,000 5,000 4,000 3,000 1,000
388 Cumulative cash flow -10,000 -5,000 -1,000 2,000 3,000
389 Intermediate calculation for payback - - - 2.33 5.00
390
391 Intermediate calculation:
392 Manual calculation of Payback S = 2 + $1,000/$3,000 = 2.33 =IF(F388>0,E386+ABS(E388/F387),"-")
393 Excel calculation of Payback S = 2.33 2.33
394
395 Years 0 1 2 3 4
396 Project L Cash flow -10,000 1,000 3,000 4,000 6,750
397 Cumulative cash flow -10,000 -9,000 -6,000 -2,000 4,750
398
399 Manual calculation of Payback L = 3 + $2,000/$6,750 = 3.30 Payback is between
400 Alternative Excel calculation of Payback L = negative and positive
cumulative cash flow.
401 =PERCENTRANK(C397:G397,0,6)*G395 = 3.30
402
403
404
405
406
The regular payback has two major flaws. First, it does not take account of any cash flows that occur past the
payback year, no matter how large those flows might be. Second, the payback does not take account of the time
407
value of money. This second problem is addressed with the discounted payback as discussed below, but the failure to
408
consider beyond-payback cash flows is a problem for both payback methods.
409
410
411
412 Figure 10-10. Discounted Payback
413
414 WACC = 10%
415 Years = 0 1 2 3 4
416 Project S Cash flow -10,000.00 5,000.00 4,000.00 3,000.00 1,000.00
417 Discounted cash flow -10,000.00 4,545.45 3,305.79 2,253.94 683.01
418 Cumulative discounted CF -10,000.00 -5,454.55 -2,148.76 105.18 788.20
419
420 Discounted Payback S = 2 + $2,148.76/$2,253.94 = 2.95 Payback is between
421 Excel calculation of Discounted Payback S = negative and positive
422 =PERCENTRANK(C418:G418,0,6)*G415 = 2.95 cumulative discounted cash
423 flow.
424 Years 0 1 2 3 4
425 Project L Cash flow -10,000.00 1,000.00 3,000.00 4,000.00 6,750.00
426 Discounted cash flow -10,000.00 909.09 2,479.34 3,005.26 4,610.34
427 Cumulative discounted CF -10,000.00 -9,090.91 -6,611.57 -3,606.31 1,004.03
428
429 Discounted Payback L = 3 + $3,606.31/$4,610.34 = 3.78 Payback is between negative
430 Excel calculation of Discounted Payback L = and positive cumulative
431 =PERCENTRANK(C427:G427,0,6)*G424 = 3.78 discounted cash flow.
432
433
434
435 CONCLUSIONS ON CAPITAL BUDGETING METHODS (Section 10.10)
436
437 NPV is the single best criterion because it provides a direct measure of the value a project adds to shareholder
 A single best criterion
NPV is the B C
because it provides a directDmeasure of theEvalue a project
F adds to shareholder
G H
438 wealth. However, all methods provide helpful information.
439
440
441 DECISION CRITERIA USED IN PRACTICE (Section 10.11)
442
443 NPV and IRR are the most widely used methods.
444
 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.

Figure 10A-1. Accounting Rate of Return

Average annual cash inflows – Average annual depreciation

ARR =
Average Investment

Project S Project L
Average CF $3,250 $3,687.50
Average Depreciation $2,500 $2,500
Years 4 4
Investment $10,000 $10,000
Avg. Investment $5,000 $5,000
$750
ARRS = = 15.00%
$5,000

$1,187.50
ARRL = = 23.75%
$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.
 4/11/2010
n

s of the ARR, but the

$2,500 of depreciation

e IRR and the MIRR

ness.
SECTION 10.2
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

4. 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 10.3
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.
SECTION 10.4
SOLUTIONS TO SELF-TEST QUESTIONS

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%
 Multiple IR Rs: Proje ct MM

SECTION 10.6
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 10.8
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 = 1.321391
SECTION 10.9
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.