Problem

Assume you believe you need 2,000,000 when you retire (Age 50) and you are
now 25 years old. How much will you need to deposit each year at the end of th
year if your account earns 8% each year?

Sensitivity Analysis

What if your account earns 8.8% each year? Or 7.2% each year?

N 25
FV 2000000
R 8%

Annuity ₹ 27,357.56 PMT(C20,C18,0,-C19,0)

₹ 27,357.56
8.80% 24322.44489
7.20% 30724.44406
Age 50) and you are
year at the end of the
?

r?
Chapter 6 503877525.xls

General Excel Template

Topic: Net Present Value (NPV) and Internal Rate of Return (IRR)

A central goal in financial management is to undertake those decisions that create

value for shareholders. Therefore, it is of central importance to develop techniques
that enable financial decision makers to identify those investment opportunities that
generate value (as opposed to those that do not).

The capital budgeting techniques of net present value (NPV) and internal rate of
return (IRR) are uniquely designed to accomplish this key organizational objective.

Net Present Value (NPV)

=NPV(rate,value1,[value2],[value3],…)
The NPV of an investment is the difference between the measured market value of
an investment (frequently estimated as the present value of the future cash flows
expected from the investment) and the original cost of the investment.

The decision criteria for NPV are as follows:

▪ When NPV is positive, accept the investment.
▪ When NPV is negative, reject the investment.
NPV can also be used to rank multiple mutually-exclusive investments; the
investment with the highest NPV would be the one with the greatest potential value
for shareholders.

Internal Rate of Return (IRR)

=IRR(values,[guess])

The IRR of an investment is that discount rate that generates an NPV of zero (which
would make the financial decision maker indifferent to accepting or rejecting the
investment).
The decision criteria for IRR are as follows:
▪ When IRR exceeds the required return, accept the investment.
▪ When required return exceeds IRR, reject the investment.
IRR and NPV as decision criteria always present the same conclusion for
conventional independent-investment decisions. However, when an investment is
not conventional, IRR may not exist. Also, IRR cannot rank multiple mutually-
exclusive investments.

Copyright © 2009 Pearson Education Canada Page 3 of 45

Chapter 6 503877525.xls

Suppose your company is attempting to evaluate a particular project with the

following cash flows:

Cash
Year Flow
1 $5,000
2 $14,000
3 $12,000
4 $15,000
5 $9,000
6 $12,000
7 $20,000
8 $40,000

The project costs $80,000 today and the required return on investments of this type
is 8%. Calculate both NPV and IRR and determine whether or not you should
undertake the project.

NPV
The NPV calculation is used to determine the present value
of the future expected cash flows from the investment (this
is the measured market value of the investment). By
subtracting the $80,000 cost of the investment, the net
benefit (or loss) of the investment can then be determined.

Particular attention should be paid to the value arguments in

the NPV function. The values that the NPV function
considers begin in period 1. Therefore, cash flows that
occur before then period 1 must be considered separately.
The resulting NPV of the project is positive, indicating that
the project should be accepted since it increases
shareholder wealth.

Copyright © 2009 Pearson Education Canada Page 4 of 45

Chapter 6 503877525.xls

IRR
Cash
Year Flow
0 -$80,000
1 $5,000
2 $14,000
3 $12,000
4 $15,000
5 $9,000
6 $12,000
7 $20,000
8 $40,000

IRR
Unlike the value arguments in the NPV function, the value
arguments in the IRR function begin immediately. As a
result, we can add in the original cost of the project, which
occurs in period zero.
The selection criteria for IRR is "accept a project as long as
its IRR exceeds the required return." Since this project's
IRR of 9.08% exceeds the required return of 8%, the project
should again be accepted.

Copyright © 2009 Pearson Education Canada Page 5 of 45

Annual RRR (Discount) 0.15 N PV Excel Function &
Cash Flow 0 (Cost) -$200,000.00
NPV Function:
Cash Flow 1 $100,000.00
=NPV(rate,value1,value2…
Cash Flow 2 $90,000.00
⃰ rate = Period Discount Ra
Cash Flow 3 $70,000.00 ⃰ value1 = Range of cells w
⃰ Cash flows must happen a
NPV =Value added to period.
firm if project is ⃰ Cash flows start at time 1.
undertaken ⃰ Never include cash flows at tim
⃰ Cash flows do not have to
=NPV(rate, value1, value2, …) + CF0 ⃰ Time between each cash f

=NPV(i/n, CF1, CF2, …) + CF0

NPV Formula when cost
Note: value1 can be the whole range of cash flows =NPV(rate,value1,va

Discount R 15%

Cash
Year
Flows
0 -200000
NPV 1035.59 1 100000
NPV(F14,F18:F20)+F17 2 90000
3 70000

PV
NPV
V Excel Function & Formula
Function:
(rate,value1,value2…)
ate = Period Discount Rate = i/n.
alue1 = Range of cells with cash flows.
ash flows must happen at the end of each
eriod.
Cash flows start at time 1.
Never include cash flows at time 0 (zero).
ash flows do not have to be equal in amount.
me between each cash flow must be the same.

Formula when cost is at time 0:

=NPV(rate,value1,value2…) - Cost
12

Discount R 15%

PV (Cash Cash PV (Cash

Year
Flows) Flows Flows)
0 -200000
86956.52 1 100000 ₹ 86,956.52
68052.93 2 90000 ₹ 68,052.93
46026.14 3 70000 ₹ 46,026.14

201035.6 PV ₹ 201,035.59
1035.588 NPV ₹ 1,035.59
Calculate NPV
8%
Data
-40000
8000
9200
10000
12000
14500
-9000

NPV
IRR
Annual discount rate. This might represent the rate of inflation or the interest rate of a competing investment.
Description
Initial cost of investment
Return from first year
Return from second year
Return from third year
Return from fourth year
Return from fifth year
Return from Sixth year

($3,749.47)
4%
Calculate NPV

NPV/IRR Calculations
10% Annual discount rate
Cash Flows Description
-10000 Initial cost of investment one year from today
3000 Return from first year
4200 Return from second year
6800 Return from third year

NPV $1,188.44
IRR

Year Cash Flow PV of Cash Flows

1 -10000 $9,090.91
2 3000 $2,479.34
3 4200 $3,155.52
4 6800 $4,644.49
NPV ₹ 1,188.44
Period Cash Flow
Initial Investment -1000
Year 1 100
Year 2 600
Year 3 300
Year 4 400
Year 5 500
RRR 9%

NPV 445.00

IRR 23%
 Consider the project of opening a new super store with an investent of 5400000. The pro
years are 12000000. Variable costs are 81.25% of sales. Fixed costs are 2000000. Depric
on straight line basis and tax rate is 40%. Opportunity cost of capital is 8%. FInd the
 tent of 5400000. The projeted Sales for next 1-12
costs are 2000000. Depriciation is assumed to be
of capital is 8%. FInd the NPV of the project
 Consider the project of opening a new super store with an investment of 5400000. The p
next 1-12 years are 16000000. Variable costs are 81.25% of sales. Fixed costs are 20000
assumed to be on straight line basis and tax rate is 40%. Opportunity cost of capital is 8%
the project. Show the impact of change in sales on NPV and Cash Flows. Also show the
optimistic views on NPV by changing sales, variable costs and fixed cost

I 8%
n 12 Annuity 12.5 4.96392198
Original
5400000
Cost
Depriciati
450000 pvifa 7.53607801693
on
Tax % 40%
Sales 16000000 A 780000
Varaibale
Cost 13000000 81.25%
Fixed
Cost 2000000 PV A 5878140.8532
Depriciati
on 450000 Original Cos 5400000
EBIT 550000
Tax 220000 NPV 478140.853202
Earnings 330000
Depriciati
on 450000

Cash
Flow 780000

Year 0 1 2 3 4 5
Cash Flows -5400000 780000 780000 780000 780000 780000

NPV 478140.85

478140.85 780000
16000000 478140.85 780000
18000000 2173758.4 1005000
17000000 1325949.6 892500
15000000 -369667.92 667500
18500000 2597662.8 1061250
 RANGE
Variable Pessimistic Expected Optimistic

ent of 5400000. The projeted Sales for Investment 6200000 5400000 5000000
Fixed costs are 2000000. Depriciation is
ty cost of capital is 8%. FInd the NPV of Sales 14000000 16000000 18000000
Flows. Also show the pessimistic and Variable
83% 81.25% 80%
Cost
e costs and fixed costs
Fixed
2100000 2000000 1900000
Costs

6 7 8 9 10 11 12
780000 780000 780000 780000 780000 780000 780000
Consider the project of opening a new super store with an investment of 5400000. The pro
1-12 years are 16000000. Variable costs are 81.25% of sales. Fixed costs are 200000
assumed to be on straight line basis and tax rate is 40%. Opportunity cost of capital is 8%.
project. Show the impact of change in sales on NPV and Cash Flows. Also show the pessi
views on NPV by changing sales, variable costs and fixed costs
 RANGE
Variable Pessimistic Expected Optimistic

Investment 6200000 5400000 5000000

of 5400000. The projeted Sales for next
Sales 14000000 16000000 18000000
ed costs are 2000000. Depriciation is
Variable
cost of capital is 8%. FInd the NPV of the Cost
83% 81.25% 80%
Also show the pessimistic and optimistic
s and fixed costs Fixed
2100000 2000000 1900000
Costs
 Internal Rate of Return IRR
This example involves the decision to purchase a new machine to replace an old one. JonesCo needs to purchase a new mac
that will provide the same function. Machine A cost $100,000 and would provide savings of $25,000 for the next five years. Ma
provide savings of $20,000 for the next 5 years. The company's discount rate is 10%.
10%
Machine A Time
0 1 2 3 4 5 NPV IRR
Cash flows -$100,000 $25,000 $25,000 $25,000 $25,000 $25,000 ($5,230.33) 8%

Machine B Time
0 1 2 3 4 5 NPV IRR
Cash flows -$75,000 $20,000 $20,000 $20,000 $20,000 $20,000 $815.74 10%

Machine A costs more than machine B but also provides higher savings than machine B in the future. Both machines have tota
the machine. IRR analysis can be used to find out which machine will provide the highest return on investment.

Machine A Machine B
IRR IRR
eturn IRR
eeds to purchase a new machine and has a choice of two machines
00 for the next five years. Machine B cost $75,000 and would

ure. Both machines have total savings of $25,000 over the cost of
n investment.
 Should we launch new product that will be around 5
years that has these cash flows?

Time All Cash Out All Cash In Net Cash Flows

Time 0 -100,000.00 -100,000.00
Time 1 -28,000.00 80,000.00 52,000.00
Time 2 -16,500.00 60,000.00 43,500.00
Time 3 -15,000.00 40,000.00 25,000.00
Time 4 -10,000.00 35,000.00 25,000.00
Time 5 -20,000.00 18,000.00 -2,000.00

Required Rate Of Return Annual RRR (Discount)

NPV
Answer:
IRR
NPV Profile
Annual RRR + NPV: Accept -NPV: Reject
5%
6%
7%
8%
9%
10%
11%
12%
13%
14%
15%
16%
17%
18%
19%
20%
21%
22%
23%
24%
25%
26%
27%
28%
29%
30%
31%
32%
33%
34%
35%
36%
Following are the cash inflows (in Rs.) related to Independent Project PQR and Project XYZ. Cost of capital of firm is 15%

Year 0 Year 1 Year 2 Year 3 Year 4

Project PQ -50,000 25,000 10,000 25,000 30,000
Project XY -80,000 40,000 25,000 25,000 25,000
Find (i) NPV (ii) IRR and suggest whether you should invest in projects or not and why?
t of capital of firm is 15% and increasing by 1% each year.
 Years Required to Pay Back Investment = 2
Year Pro A Pro B Pro C
0 -250.00 -250.00 -250.00
1 125 100 100
2 125 100 200
3 -250 100
4 250 100

Required R 15%
 Initial Investment C0
Payback= =
Annual Cash Inflow C
Discounted Payback Illustrated
 Project Cash Flows
CF0 -160,000.00
CF1 60,000.00
CF2 70,000.00
CF3 90,000.00
Years Required to Pay
Back Investment 2
Suppose a company uses only debt and internal equity to Finance its capital budget and uses CAPM to compute its cost of eq
25% internal equity. Before tax cost of debt is 12.5 % and tax rate is 20%. Cost f equity is 18%. Ca
 to compute its cost of equity. The capital structure is 75% debt and
. Cost f equity is 18%. Calculate WACC.
If the weighting of equity in total capital is 1/3, that of debt is 2/3, the return on equity is 15% that of debt is 10% and the corpor
Weighted Average Cost of Capital (WACC)?
a) 10.533%
b) 7.533%
c) 9.533%
d) 11.350%
ebt is 10% and the corporate tax rate is 32%, what is the
THE WEIGHTED AVERAGE COST OF CAPITAL

The weighted average cost of capital (WACC) is calculated using the firm's target capital structure together with
its after-tax cost of debt, cost of preferred stock, and cost of common equity.

PROBLEM
A firm's target capital structure consists of 30 percent debt, 10 percent preferred stock, and 60 percent common equity. Us
weighted average cost of capital?

wd = 0.3 rd = 6.6
wp = 0.1 rp = 10.25641
ws = 0.6 rs = 14.58667
rcent common equity. Using the relevant costs calculated previously, what is the firm's
t of capital?
Electronics Galore has 950,00 shares of common stock outstanding at a market price of 38 a share. The company also has 4
value. What weight should be given to the debt when the firm computes its weighted a
 The company also has 40,000 bonds outstanding that are quoted at 106 percent of face
m computes its weighted average cost of capital?
A company with a tax rate of 30% has the following capital
Weight Instrument Pre-tax cost of capital
40% Bonds 6%
50% Ordinary shares 12%
10% Preference shares 8%
What is the company’s weighted average cost of capital?
wing capital structure:
of capital

f capital?
 NPV, IRR and Payback

Jane is working on an investment project for her site. Besides working on technical specifications, she needs to put te numbers
feasible solution. After meeting with the oprations manager and diffferent suppliers, she comes up with the base case scenari
and recieving 400 from 1 through 4 years at discount rate of 20%. Analyse the base case outcomes as manager is not happy
He advised her to make more optimistic assumptions. Reduce initial investmnet, find additional benefits of 25 eah year as incre
to extend the benefits to first quarter of next year and analyse the optimistic outcomes with respect to base year. The manage
apprehensions about the feasible outcomes. Kindly recommend Jane with te optimum and feasible solutions through risk in
methods.
e needs to put te numbers together to get the
th the base case scenario of investing 1000
as manager is not happy with the outcomes.
its of 25 eah year as incremental savings or
o base year. The manager again show some
solutions through risk in capital budgeting
 NPV, IRR and Payback

Jane is working on an investment project for her site. Besides working on technical specifications, she needs to put te numbe
feasible solution. After meeting with the oprations manager and diffferent suppliers, she comes up with the base case scenario
recieving 400 from 1 through 4 years at discount rate of 20%. Analyse the base case outcomes as manager is not happy wi
advised her to make more optimistic assumptions. Reduce initial investmnet, find additional benefits of 25 eah year as increm
extend the benefits to first quarter of next year and analyse the optimistic outcomes with respect to base year. The manage
apprehensions about the feasible outcomes. Kindly recommend Jane with te optimum and feasible solutions through risk in
methods.

Base Case Scenario Scenario I

PV Cumulative
0 Initial Inve -1000 0 Initial Inve -900
1 Cash Flow 400 ₹ 333.33 ₹ 333.33 1 Cash Flow 400
2 Cash Flow 400 ₹ 277.78 ₹ 611.11 2 Cash Flow 400
3 Cash Flow 400 ₹ 231.48 ₹ 842.59 3 Cash Flow 400
4 Cash Flow 400 ₹ 192.90 ₹ 1,035.49 4 Cash Flow 400
Discount R 20% Discount R 20%

NPV 35.49 NPV 135.49

IRR 22% IRR 28%
PayBack 3.816 PayBack 3.2976
 cations, she needs to put te numbers together to get the
mes up with the base case scenario of investing 1000 and
comes as manager is not happy with the outcomes. He
al benefits of 25 eah year as incremental savings or to
respect to base year. The manager again show some
nd feasible solutions through risk in capital budgeting

Scenario II
PV Cumulative PV Cumulative
0 Initial Inve -1000
₹ 333.33 ₹ 333.33 1 Cash Flow 425 ₹ 354.17 ₹ 354.17
₹ 277.78 ₹ 611.11 2 Cash Flow 425 ₹ 295.14 ₹ 649.31
₹ 231.48 ₹ 842.59 3 Cash Flow 425 ₹ 245.95 ₹ 895.25
₹ 192.90 ₹ 1,035.49 4 Cash Flow 425 ₹ 204.96 ₹ 1,100.21
Discount R 20%

NPV 100.21
IRR 25%
PayBack 3.511059
Scenario III
PV Cumulative
0 Initial Inve -1000
1 Cash Flow 400 ₹ 333.33 ₹ 333.33
2 Cash Flow 400 ₹ 277.78 ₹ 611.11
3 Cash Flow 400 ₹ 231.48 ₹ 842.59
4 Cash Flow 400 ₹ 192.90 ₹ 1,035.49
5 Cash Flow 425 ₹ 170.80 ₹ 1,206.29
Discount R 20%
NPV 206.29
IRR 29%
PayBack 3.816
Calculate Basic EPS from the below given Data: Date Share Issue
01
January, 100000 Shares
2018

Albatross Inc Net Income – $1,000,000. Additional data 01 April,

20000 shares Issued
provided below 2018

100,000 Class A shares preferred cumulative shares, dividend amount 01 June, 30000 shares
$2.00/share 2018 repurchased
01
50,000 Class B shares preferred non cumulative shares, dividend October, 50000 Shares Issued
amount $1.50/share 2018
31
No Dividend declared or paid in the current year December, Closing Balance
2018
Market price is 190
 Date Share Issue
Calculate Basic EPS from the below given Data:
01
January, 100000 Shares
2018

Albatross Inc Net Income – $1,000,000. Additional data 01 April,

20000 shares Issued
provided below 2018

100,000 Class A shares preferred cumulative shares, dividend amount 01 June, 30000 shares
$2.00/share 2018 repurchased
01
50,000 Class B shares preferred non cumulative shares, dividend October, 50000 Shares Issued
amount $1.50/share 2018
31
No Dividend declared or paid in the current year December, Closing Balance
2018
Market price is 190

Calculation of Net Income

Net Income 1000000 EPS

Class A Dividend 200000
Class B Dividend 75000 275000 EPS

Income Available for Equity 725000

 AvgShare
Issue

100000 0.25 25000

120000 0.166667 20000

90000 0.333333 30000

140000 0.25 35000

140000

110000

Income Available for Equity/ Avg Share

6.590909