A B C D E F G

12 In this file we use Excel to do most of the calculations explained in the textbook. First, we analyze
13 Projects S and L, whose cash flows are shown immediately below in time line formats. Spreadsheet
14 analyses can be set up vertically, in a table with columns, or horizontally, using time lines. For short
15 problems, with just a few years, we generally use the time line format because rows can be added and we
16 can set the problem up as a series of income statements. For long problems, it is often more convenient to
17 use a vertical layout.
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, CFt
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 $6,750
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
49 discounted cash 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
 A B C D E F G
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
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
68
The NPV criterion says that all independent projects that have positive NPV should accepted. The
rationale for this is that all such projects add wealth, and that should be the overall goal of the manager in
69
all respects. If strictly using the NPV method to evaluate two mutually exclusive projects, you would want
70
to accept the project that adds the most value (i.e. the project with the higher positive NPV). Hence, if
71
considering the above two projects, you would accept both projects if they are independent, and you
72 would only accept Project L if they are mutually 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
79 inflows to its outflows. In other words, the internal rate of return is the interest rate that forces NPV to
80 zero. The calculation for IRR can be tedious, but Excel provides an IRR function that merely requires
81 you to access the function and 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
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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
 A B C D E F G
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
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102 IRRL = 13.55% =IRR(B100:F100) using IRR function
103
104
105
106 The IRR method of capital budgeting maintains that projects should be accepted if their IRR is greater
107 than the cost of capital. Strict adherence to the IRR method would further dictate that mutually exclusive
108
projects should be chosen on the basis of the greater IRR. In our example, each project has an IRR that
exceeds the cost of capital (10%) so both projects should be accepted if they are independent. If, however,
109 the projects are mutually exclusive, we would choose Project S because it has the higher IRR. Recall that
this differs from our conclusion when using the NPV method. So, we have a conflict between the NPV
110 and the IRR methods for ranking Projects S and L.

111
112
113 MULTIPLE IRRS (Section 10.4)
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 A B C D E F G
115 Because of the mathematics involved, it is possible for some (but not all) projects that have more than one
116 change of signs in the cash flows to have more than one IRR. If you attempted to find the IRR with such
117 a project using a financial calculator, you would get an error message. The HP-10B says "Error - Soln",
118 the HP-17B says '"Many/No Solutions, and the HP12C says Error 3; Key in Guess." The procedure for
119 correcting the problem is to store in a guess for the IRR, and then the calculator will report the IRR that
120 is closest to your guess. You can then use a different "guess" value, and you should be able to find the
other IRR. However, the nature of the mathematics creates a scenario in which one IRR is quite
121 extraordinary (often, several hundred 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
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130 r = 10% NPV = -$0.774
131
132 NPV
133 (Millions)
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135 $0.90
NPV = −$1.6 + $10/(1+r) + (−$10)/(1+r)2
136
137 $0.70
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$0.50
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142 $0.30
143 IRR #1 = 25% IRR #2 = 400%
144
$0.10
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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
156 rate at which the NPV = 0, there are two IRRs.
157
158 r NPV
 A B C D E F G
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
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.
189 Generally, MIRR is defined as reinvestment at the WACC, though Excel allows the calculation of MIRR where
190 reinvestment is likely to occur at a different rate than WACC.
191
192 As is stated in the text, NPV is superior to the IRR because (1) the NPV assumes that cash flows are reinvested at
193 the cost of capital whereas the IRR assumes reinvestment at the IRR, and (2) it is more likely, in a competitive
194 world, that the actual reinvestment rate will be the cost of capital than the IRR, especially if the IRR is quite high.
195 The MIRR setup can be used to prove that NPV indeed does assume reinvestment at the WACC and IRR at the
196 IRR.
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.
 A B C D E F G
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
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)
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236 An NPV profile shows how a project's NPV declines as the WACC used to calculate the NPV increases. Figure 10-
237 4, 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
 A B C D E F G
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
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263 $2,000 NPVS = 0, so IRR = 14.489%
264
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273 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%
274
275 Cost of Capital (%)
276 -$1,000
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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
285 find the crossover rate is to subtract one project's cash flows from the others and find the IRR of this differential
286 cash 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
 A B C D E F G
293
294 IRR D = 11.975%
295
296
 A B C D E F G
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
$4,000 left of crossover, no conflict if
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 NPV L > NPVS

320
$2,000
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324
$1,000
325
326 IRRS > IRRL
327 NPVS at WACC
328
$0
329
0% 10% 20% Cost of Capital 30%
330
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332 IRRL
333 -$1,000
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337 -$2,000
338
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340
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342 PROFITABILITY INDEX (PI) (Section 10.8)
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344 The profitability index is the present value of all future cash flows divided by the intial cost. It measures the PV
per dollar of investment.
 A B C D E F G
345 per dollar of investment.
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347
348
349 Figure 10-8. Profitability Index (PI)
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351 Project S: PIS = PV of future cash flows ÷ Initial cost
352 PIS = $10,788.20 ÷ $10,000
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
371
it the unrecovered balance at the end of that year divided by the following year's cash flow. Generally speaking,
372 the shorter the payback period, the better the investment.
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374
375
It's easy to calculate the payback manually--calculate cumulative cash flows and look to see when the cumulative
376 CF turns positive, and recognize that the payback year is the prior year plus a fraction equal to the shortfall
377 divided by the CF in the next year. However, it would be useful to have an automated procedure if you were
378 calculating many paybacks or if you wanted to do sensitivity analysis for a given project, but this is more
379 complicated. You can see the formula below, and the procedure is explained in detail in our Excel Tutorial. We use
380 the formula only if we must do a number of payback calculations--for just one or two, the manual approach is
much easier.
381
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383
 A B C D E F G
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
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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
408
to 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
and positive cumulative
discounted cash flow.
 A B C D E Payback F G
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
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
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rojects, you would want
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ve NPV). Hence, if
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pendent, and you
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value of a 78
project's cash
e that forces
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hat merely80requires
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their IRR
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that mutually
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oject has108
an IRR that
ependent. If, however,
gher IRR.109Recall that
t between the NPV
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hat have 115
more than one
nd the IRR116 with such
B says "Error
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" The procedure
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ll report 119
the IRR that
d be able120
to find the
e IRR is quite
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nition of the
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alistic to asssume
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ision criterion than IRR.
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177to equal the
h outflows)
he future178 values of the
te the PV 179
of the outflows
an solve using
180 Excel's
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h flows received are
ore likely,184
the MIRR is a
as a set of185
cash flows can
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187
different188
rates.
tion of MIRR
189 where
190
191
flows are 192
reinvested at
193
ely, in a competitive
if the IRR194 is quite high.
WACC and195 IRR at the
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at the cost of capital and
ccurred in199 a given year,
st dealing200with the net
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236 Figure 10-
PV increases.
hange sign237only once--a
PV profiles238
look like the
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t. It measures
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han 1.0. 359
PI. 360
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vestment,369and it was the
r in which370the cumulative
previous year and add to
371
. Generally speaking,
372
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375
see when the cumulative
ual to the 376
shortfall
377 were
cedure if you
ut this is 378
more
r Excel Tutorial.
379 We use
manual approach
380 is
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s that occur
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ke account of the time
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tween negative
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e cumulative
d cash flow.431
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adds to shareholder
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