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
E x a m p le : Y ie ld o n a s in g le re c e ip t.

A n in v e s to r c a n p u r c h a s e a v a c a n t lo t f o r $ 2 8 ,3 7 1 a n d e x p e c ts
to s e ll it fo r $ 5 0 ,0 0 0 in 5 y e a rs . W h a t is th e e x p e c te d I R R fo r
th is in v e s tm e n t?

1
P V  F V
(1  d ) n

1
$ 2 8 ,3 7 1  $ 5 0 ,0 0 0
(1  d ) 5

d = 12%
 IRR and NPV
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1 P/YR One payment per year
28371 +/- PV PV = -$ 28,371
50000 FV FV = $ 50,000
5 N FV in 5 years
I/YR Solve for IRR
 IRR and NPV
E x a m p le : N P V fo r a s in g le re c e ip t.

A n in v e s to r c a n p u r c h a s e a v a c a n t lo t fo r $ 2 8 ,3 7 1 a n d e x p e c ts to s e ll it fo r
$ 5 0 ,0 0 0 in 5 y e a r s . W h a t is th e e x p e c te d N P V fo r th is in v e s tm e n t if th e
in v e s to r d is c o u n ts fu tu re c a s h flo w s a t 1 5 % ?

1
N PV   PV  FV
(1  d ) n

1
N P V   $ 2 8 ,3 7 1  $ 5 0 ,0 0 0
( 1  0 .1 5 ) 5

N P V = - $ 2 8 ,3 7 1 + $ 2 4 ,8 5 8 .8 4 = - $ 3 ,5 1 2 .1 6
 IRR and NPV
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1 P/YR One payment per year
50,000 FV $50,000 future value
15 I/YR Discount rate = 15%
5 N
FV in 5 years
+/-
PV
Compute present value
- 28,371 =
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?
nk
1
PV  PMT
d
t1 (1 )t
k
96
1
. 
$28,371 44566
t1 (1
d t
)
12
d
 09167%
. ; d  110% .
12
 IRR and NPV
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12
P/YR
Monthly compounding
+/-
28,371
PV
PV = - $28,371
445.66 PMT
Monthly pmt = $445.66
8 x P/YR
96 months
I/YR
Compute IRR
 IRR and NPV
E x a m p le : N P V fo r a n O rd in a ry A n n u ity

A n in v e s to r h a s th e o p p o rtu n ity to in v e s t in re a l e s ta te c o s tin g

$ 2 8 ,3 7 1 to d a y . T h e in v e s tm e n t w ill p r o v id e $ 4 4 5 .6 6 a t th e e n d o f
e a c h m o n th fo r th e n e x t 8 y e a rs . W h a t is th e N P V fo r th is
in v e s tm e n t if th e in v e s to r d is c o u n ts fu tu re c a s h flo w s m o n th ly a t a
1 0 % a n n u a l ra te ?
96
1
N P V   $ 2 8 , 3 7 1  4 4 5 .6 6  0 .1 0 t
t1
(1  )
12

NPV = - $ 2 8 ,3 7 1 + $ 2 9 ,3 6 9 .6 6 = $ 9 9 8 .6 6
 IRR and NPV
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12
P/YR Monthly payments
445.66
PMT Monthly pmt = $445.66
10 I/YR
Annual discount rate = 10%
8 x P/YR
96 monthly payments
PV +/-

- 28,371 =
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?

nk
1 FV
PV  PMT  
d
t  1 (1  ) t
d nk
(1  )
k k

60
1 $97,662 .97
$96,000  $1,028.61 
t  1 (1 
d t d 60
) (1  )
12 12

d/12 = 1.0921% ; d = 13.10%

 IRR and NPV
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12
P/YR
Monthly payments
96,000 +/- PV
PV = -$96,000
1,028.61 PMT
Monthly pmt = $1,028.61
97,662.97 FV
FV = $97,662.97
5 x P/YR
60 months
I/YR
Compute yield (IRR)
 IRR and NPV
E x a m p le : N P V fo r a n o rd in a ry a n n u ity w ith a n a d d itio n lu m p
s u m re c e ip t a t th e e n d o f th e in v e s tm e n t te rm .

W h a t is th e N P V f o r a n in v e s tm e n t th a t c o s ts $ 9 6 ,0 0 0 to d a y
a n d p a y s $ 1 0 2 8 .6 1 a t th e e n d o f th e m o n th f o r th e n e x t 6 0
m o n th s a n d th e n p a y s a n a d d itio n a l $ 9 7 ,6 6 2 .9 7 a t th e e n d o f
th e 6 0 th m o n th if th e in v e s to r d is c o u n ts e x p e c te d fu tu re c a s h
f lo w s m o n th ly a t th e a n n u a l r a te o f 1 3 .1 0 4 7 % ?
nk
1 FV
N PV   PV  PM T t  1 d t 
d nk
(1  ) (1  )
k k
60
1 $ 9 7 , 6 6 2 .9 7
N P V   $ 9 6 , 0 0 0  $ 1 , 0 2 8 .6 1  
t1 (1 
0 .1 3 1 0 4 7 t 0 .1 3 1 0 4 7 6 0
) (1  )
12 12

N P V = - $ 9 6 ,0 0 0 + $ 9 6 ,0 0 0 = $ 0
 IRR and NPV
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Monthly payments
12 P/YR
Monthly pmt = $1,028.61
1,028.61 PMT
FV = $97,662.97
97,662.97 FV
60 months of payments
5 x P/YR
Discount rate = 13.1047%
I/YR
13.1047
Compute PV
PV +/-
Subtract $96,000
- 96,000 =
 IRR and NPV

E x a m p le : I R R fo r u n e v e n c a s h flo w s .

W h a t i s t h e I R R f o r a n i n v e s t m e n t t h a t c o s t s $ 1 0 0 ,0 0 0 t o d a y
a n d p a y s $ 2 0 ,0 0 0 o n e y e a r f r o m t o d a y ; $ 3 5 ,0 0 0 t w o y e a r s f r o m
t o d a y ; a n d $ 7 5 ,0 0 0 t h r e e y e a r s f r o m t o d a y ?

$ 2 0 ,0 0 0 $ 3 5 ,0 0 0 $ 7 5 ,0 0 0
$ 1 0 0 ,0 0 0   
(1  d ) (1  d ) 2
(1  d ) 3

d  1 1 .5 9 %
 IRR and NPV
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1 P/YR
One payment per year
100,000 +/- CFj
Initial CF = - $100,000
20,000 CFj
1st CF = $ 20,000
35,000 CFj
2nd CF = $ 35,000
75,000 CFj
3rd CF = $ 75,000
IRR/YR
Compute yield (IRR)
 IRR and NPV
E x a m p le : N P V fo r u n e v e n c a s h flo w s .

W h a t is th e N P V f o r a n in v e s tm e n t th a t c o s t s $ 1 0 ,0 0 0 to d a y ,
$ 8 ,0 0 0 o n e y e a r f r o m to d a y , $ 5 ,0 0 0 tw o y e a r s f r o m to d a y a n d
p a y s $ 1 5 ,0 0 0 th r e e y e a r s f r o m to d a y a n d $ 2 5 ,0 0 0 f o u r y e a r s
fro m to d a y if fu tu re c a s h flo w s a re d is c o u n te d a t 1 0 % ?

$ 8 ,0 0 0 $ 5 ,0 0 0 $ 1 5 ,0 0 0 $ 2 5 ,0 0 0
N P V   $ 1 0 ,0 0 0   2
 3

1 .1 1 .1 1 .1 1 .1 4

N P V = -$ 1 0 ,0 0 0 - $ 7 ,2 7 2 .7 3 - $ 4 ,1 3 2 .2 3 + $ 1 1 ,2 6 9 .7 2 + $ 1 7 ,0 7 5 .3 4

= $ 6 ,9 4 0 .1 0
 IRR and NPV
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1 P/YR One payment per year
10,000 +/- CFj Initial CF = - $ 10,000
8,000
+/- CFj 1st CF = - $ 8,000
5,000 +/- CFj 2nd CF = - $ 5,000
15,000 CFj 3rd CF = $ 15,000
25,000 CFj 4th CF = $ 25,000
10 I/YR Discount rate = 10%
NPV Compute net present value
 IRR and NPV
E x a m p le : I R R fo r g ro u p e d c a s h flo w s .

C o m p u te th e I R R f o r a n in v e s tm e n t th a t c o s ts $ 9 2 ,7 2 5 .6 0
to d a y a n d is e x p e c te d to p a y $ 1 0 ,0 0 0 a t th e e n d o f th e y e a r f o r
th e n e x t th r e e y e a r s ; $ 1 5 ,0 0 0 a t th e e n d o f y e a r s 4 a n d 5 ; a n d
$ 1 0 0 ,0 0 0 a t th e e n d o f y e a r 6 .
3 5
$ 1 0 ,0 0 0 $ 1 5 ,0 0 0 $ 1 0 0 ,0 0 0
$ 9 2 , 7 2 5 .6 0  
t1 (1  d ) t
 
t 4 (1  d ) t

(1  d ) 6
d = 12%
 IRR and NPV
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1 P/YR
One payment per year
92,725.60 +/- CFj Initial CF = - $ 92,725.60
10,000 CFj 1st grouped CF = $ 10,000
3 Nj Occurs three times
15,000 CFj 2nd grouped CF = $ 15,000
2 Nj Occurs twice
100,000 CFj
3rd CF = $ 100,000 (once)
IRR/YR
Compute the yield (IRR)
 IRR and NPV
E x a m p le : N P V fo r g ro u p e d c a s h flo w s .

C o m p u te th e N P V
e x p e c te d to p a y $ 7
th e e n d o f e a c h m o
e a c h m o n th fo r th e
$ 1 0 7 ,4 9 1 .1 8 a t th e
flo w s m o n th ly a t a
fo r a n in v e s tm e n t th a t c o s ts $ 9 8 ,0 0 0 to d a y a n d is
9 1 .3 8 a t th e e n d o f e a c h m o n th fo r 1 2 m o n th s ; $ 8 5 0 .7 3 a t
n th fo r th e fo llo w in g 1 2 m o n th s ; $ 9 1 4 .5 4 a t th e e n d o f
fo llo w in g 1 1 m o n th s a n d a b a llo o n p a y m e n t o f
e n d o f m o n th 3 6 if th e in v e s to r d is c o u n ts fu tu re c a s h
1 3 % a n n u a l ra te .

N P V = - $ 5 5 4 .1 7 = - $ 9 8 ,0 0 0 +
12 24 35
1 1 1 $ 1 0 7 , 4 9 1 .1 8
$ 7 9 1 .3 8  0 .1 3 t
 $ 8 5 0 .7 3  0 .1 3 t
 $ 9 1 4 .5 4  0 .1 3 t

0 .1 3 3 6
t1 (1  ) t13 (1  ) t 25 (1  ) (1  )
12 12 12 12
 IRR and NPV
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12 P/YR
Monthly payments
Initial CF = - $98,000
98,000 +/- CFj
1st grouped CF = $791.38
791.38 CFj
Occurs 12 times
12 N j
2nd grouped CF = $850.73
850.73 CFj
Occurs 12 times
12 N j
3rd grouped CF = $914.54
914.54 CFj
Occurs 11 times
11 N j
4th CF = $107,491.18 (once)
107,491.18 CFj Discount rate = 13%
13 I/YR Compute net present value
NPV