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 IRR for to sell it for $50,000 in 5 years. What is the expected this investment?

1 PV = FV (1 + )n d
$28,371 = $50,000
d = 12%

1 (1 + ) 5 d

IRR and NPV

HP 10B Keystrokes
CLEA R ALL 1 28371 50000 5 N I/YR P/Y R +/FV PV

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 NPV $50,000 in 5 years. What is the expected for this investment if the investor discounts future cash flows at 15%?

1 NPV = PV + FV n (1 + d )
1 NPV = $28,371 + $50,000 (1 + 015) 5 .
NPV = -$28,371 + $24,858.84 = $3,512.16

IRR and NPV

HP 10B Keystrokes
CLEAR ALL 1 P/YR

50,000 FV 15 5 PV I/YR N

+/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 IRR (compounded monthly) for this next 8 years. What is the (annual) investment?

1 PV =PMT d t = (1 + )t 1 k 1 $28,371 = . 44566 d t = (1 + )t 1 12 d = .9167%; d =110% 0 . 12

96

nk

IRR and NPV

HP 10B Keystrokes

CLEAR ALL P/YR

12 28,371 445.66 8 I/YR

+/PMT x P/YR

PV

Clears registers Monthly compounding PV = - $28,371 Monthly pmt = $445.66 96 months Compute IRR

IRR and NPV

Exam ple:N PV for an O rdinary A nnuity

A n investor has the opportunity to invest in real estate costing $28,371 today. T he investm ent w ill provide $445.66 at the end each m onth for the next 8 years. W hatN P the this is Vfor investm ent if the investor discounts future cash flow s m onthly a 10% annual rate?

1 N P V = $28,371 + 44566 . 010 t . t =1 (1 + ) 12

N PV = - $28,371 + $29,369.66 = $998.66

96

IRR and NPV

HP 10B Keystrokes
Clears registers Monthly payments Monthly pmt = $445.66 Annual discount rate = 10% 96 monthly payments Compute PV Subtract $28,371

C A A LE R LL P/Y R PM T

1 2 4 5 6 4 .6 1 0 8 PV

I/Y R

xP R /Y

+ /2 ,3 1 8 7

IRR and NPV

Exam ple: W hat is IR R for an investm ent that costs $96,000 today and the pays $1028.61 at the end of the m onth for the next 60 m onths and then an additional $97,662.97 at the end of the 60th m onth?

1 FV PV = PM T + d d nk t =1 (1 + ) t (1 + ) k k 1 $97,66297 . $96,000= $1,02861 . + d t d 60 t =1 (1 + ) (1 + ) 12 12

60

nk

d/12 = 1.0921% ; d = 13.10%

IRR and NPV

HP 10B Keystrokes
CLEAR ALL P/YR

12 96,000

+/-

PV

1,028.61 PMT 97,662.97 5 I/YR FV

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%?
1 FV + d t d nk t =1 (1 + ) (1 + ) k k 60 1 $97,662.97 NPV = $96,000 + $1,028.61 + 0131047 t . 0131047 60 . t =1 (1 + ) (1 + ) 12 12 NPV = PV + PMT
nk

NPV = - $ 96,000 + $ 96,000 = $ 0

IRR and NPV

HP 10B Keystrokes
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

CLEAR ALL 12 1,028.61 97,662.97 5 P/YR PMT FV x P/YR I/YR

13.1047 PV

+/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?

$20,000 $35,000 $75,000 $100,000 = + + 2 (1 + d ) (1 + d ) (1 + d )3 d =1159% .

IRR and NPV

HP 10B Keystokes

CLEAR ALL 1 100,000 20,000 35,000 75,000 P/YR

+/CFj CFj CFj

CFj

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%?

$8,000 $5,000 $15,000 $25,000 NPV = $10,000 + + 2 3 11 . 11 . 11 . 114 .

NPV = -$10,000 - $7,272.73 - $4,132.23 + $11,269.72 + $17,075.34 = $ 6,940.10

IRR and NPV

HP 10B Keystrokes
CLEAR ALL 1 10,000 8,000 P/YR

+ /+ /+ /CFj CFj

CFj CFj CFj

5,000 15,000 25,000 10

I/YR N PV

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

Exam ple:IRR for grouped cash flows.

IRR for an investm ent that costs $92,725.60 Com pute the today and is expected to pay $10,000 at the end of the year f the next three years; $15,000 at the end of years 4 and 5; and $100,000 at the end of year 6.
$10,000 5 $15,000 $100,000 $92,72560 = . + + t t (1 + d ) t = 4 (1 + d ) (1 + d )6 t =1
d = 12%
3

IRR and NPV

HP 10B Keystrokes
CLEAR ALL 1 P/YR

92,725.60 10,000 3 15,000 2 100,000

+/-

CFj

CFj Nj CFj Nj CFj IRR/YR

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. NPV for an investment that costs $98,000 today and is Compute the expected to pay $791.38 at the end of each month for 12 months; $850.73 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 +

24 35 1 1 1 $107,49118 . $79138 . + $850.73 + $914.54 + 013 t . 013 t . 013 t . 013 36 . t = 1 (1 + t = 13 (1 + t = 25 (1 + ) ) ) (1 + ) 12 12 12 12 12

IRR and NPV

HP 10B Keystrokes
CE R L L A AL 1 2 9, 0 8 0 0 71 8 9. 3 1 2 80 3 5. 7 1 2 94 4 1. 5 1 1 17 9 . 8 0, 1 4 1 1 3 IY /R NV P PY /R

+ / Cj F N j Cj F N j Cj F N j

Cj F

Cj F

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