A 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 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59

In this file we use Excel to do most of the calculations explained in the textbook. First, we analyze Projects S and L, 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 the time line format because rows can be added and we can set the problem up as a series of income statements. For long problems, it is often more convenient to use a vertical layout.

Figure 10-1. Net Cash Flows (CFt) and Selected Evaluation Criteria for Projects S and L Panel A: Project Cash Flows and Cost of Capital
Project cost of capital, r, for each project: Initial Cost Project A Project B
0 -$42,000 -$45,000 1 $14,000 $28,000 10%

After-Tax, End of Year, Project Cash Flows, CFt

2 $14,000 $12,000 3 $14,000 $10,000 4 $14,000 $10,000 5 $14,000 $10,000

Panel B: Summary of Selected Evaluation Criteria

Project A $11,071.01 19.86% 11.53% 1.26 3.00 3.75 Project B $10,924.40 15.98% 12.77% 1.24 2.50 3.31

NPV IRR MIRR PI Payback Discounted Payback

PAYBACK PERIOD (Section 10.9) The payback period is defined as the expected number of years required to recover the investment, and it was the 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 the unrecovered balance at the end of that year divided by the following year's cash flow. Generally speaking, the shorter the payback period, the better the investment.

It's easy to calculate the payback manually--calculate cumulative cash flows and look to see when the cumulative 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 many paybacks or if you wanted to do sensitivity analysis for a given project, but this is more complicated. You can see the formula below, and the procedure is explained in detail in our Excel Tutorial. We use the formula only if we must do a number of payback calculations--for just one or two, the manual approach is much easier.

A B C D E F G H 60 Figure 10-9. Payback Period 61 62 Years = 0 1 2 3 4 5 Project A 63 Cash flow -42,000 14,000 14,000 14,000 14,000 14,000 64 Cumulative cash flow -42,000 -28,000 -14,000 0 14,000 28,000 65Intermediate calculation for payback 3.00 5.00 66 67 Intermediate calculation: Manual calculation of Payback A = 2 + $14,000/$14,000 = 3.00 68 =IF(F388>0,E386+ABS(E388/F387),"-") 69 Excel calculation of Payback A = 3.00 70 71 Years 0 1 2 3 4 5 Project B 72 Cash flow -45,000 28,000 12,000 10,000 10,000 10,000 73 Cumulative cash flow -45,000 -17,000 -5,000 5,000 15,000 25,000 74 Manual 75 calculation of Payback B = 3 + $5,000/$10,000 = 2.50 Payback is between negative and positive 76 Alternative Excel calculation of Payback B = cumulative cash flow. 77 =PERCENTRANK(C397:G397,0,6)*G395 = 2.50 78 79 80 81 The regular payback has two major flaws. First, it does not take account of any cash flows that occur past the payback 82 year, no matter how large those flows might be. Second, the payback does not take account of the time value of money. 83 84 This second problem is addressed with the discounted payback as discussed below, but the failure to consider beyond85 payback cash flows is a problem for both payback methods. 86 87 88 Figure 10-10. Discounted Payback 89 90 WACC = 10% 91 Years = 0 1 2 3 4 5 Project A 92 Cash flow -42,000.00 14,000.00 14,000.00 14,000.00 14,000.00 14,000.00 93 -42,000.00 12,727.27 11,570.25 10,518.41 9,562.19 8,692.90 Discounted cash flow 94 Cumulative discounted CF -42,000.00 -29,272.73 -17,702.48 -7,184.07 2,378.12 11,071.01 95 96 Discounted Payback A = 2 + $2,148.76/$2,253.94 = 3.68 Payback is between negative 97 Excel calculation of Discounted Payback A = and positive cumulative discounted cash flow. 98 =PERCENTRANK(C418:G418,0,6)*G415 = 3.75 99 100 Years 0 1 2 3 4 5 101 Project B Cash flow -45,000.00 28,000.00 12,000.00 10,000.00 10,000.00 10,000.00 102 -45,000.00 25,454.55 9,917.36 7,513.15 6,830.13 6,209.21 Discounted cash flow 103 Cumulative discounted CF -45,000.00 -19,545.45 -9,628.10 -2,114.95 4,715.18 10,924.40 104 105 Discounted Payback B = 3 + $3,606.31/$4,610.34 = 3.31 Payback is between negative and 106 Excel calculation of Discounted Payback B = positive cumulative discounted cash 107 =PERCENTRANK(C427:G427,0,6)*G424 = 3.31 flow. 108 109 110 111 112 Figure 10-2. Finding the NPV for Projects S and L 113 114 To calculate the NPV, we find the present value of the individual cash flows and then sum those discounted cash flows. The 115 sum is the value the project adds to or subtracts from shareholder wealth.

A 116 117 118 119 120 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149 150 151 152 153 154 Project B: 155 NPVB = Year = Project B r = 10% Year = Project A

0 (r = 10%) -42,000.00 12,727.27 11,570.25 10,518.41 9,562.19 8,692.90 $11,071.01

1 14,000

2 14,000

3 14,000

4 14,000

5 14,000

NPVS =

Long way: Sum the PVs of the CFs to find NPV

0 (r = 10%) -45,000.00 $10,924.40

1 28,000

2 12,000

3 10,000

4 10,000

5 10,000

Short way: Use Excel' s NPV function

=NPV(B51,C62:F62)+B62

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 all respects. If strictly using the NPV method to evaluate two mutually exclusive projects, you would want to accept the project that adds the most value (i.e. the project with the higher positive NPV). Hence, if considering the above two projects, you would accept both projects if they are independent, and you would only accept Project B if they are mutually exclusive. PROFITABILITY INDEX (PI) (Section 10.8) 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.

Figure 10-8. Profitability Index (PI) Project A: PIS = PV of future cash flows PIS = PIS = $53,071.01 1.2636 Initial cost Initial cost

$42,000

PIL = PV of future cash flows

PIL = $55,924.40 $45,000 PIL = 156 1.2428 157 Notes: 158 1. If Projects L and S are independent, both should be accepted as both have PI greater than 1.0. 159 However, if they are mutually exclusive, Project B should be chosen as it has the higher PI. 160 2. PI and NPV rankings will be consistent if the projects have the same cost, as is true for S and L. 161 However, if they differ in size, conflicts can occur. In the event of a conflict, the NPV ranking 162 should be used. 163 164

A 165 166 167 168 169 170 171 172 173 174 175 176 177 178 179 180 181 182 183 184 185 186 187 188 189 190 191 192 193 194 195 196 197 198 199 200 201 202 203 204 205 206 207 208

INTERNAL RATE OF RETURN (IRR) (Section 10.3)

The internal rate of return is defined as the discount rate that equates the present value of a project's cash inflows to its outflows. In other words, the internal rate of return is the interest rate that forces NPV to zero. The calculation for IRR can be tedious, but Excel provides an IRR function that merely requires you to access the function and enter the array of cash flows. The IRRs for Project A and L are shown below, along with the data entry for Project A.

Figure 10-3. Finding the IRR

r = 10.00% 0 Year = Project A -42,000.00
12,727.27 11,570.25 10,518.41 9,562.19 8,692.90 $11,071.01 19.86% 0 -45,000.00 21.65%

1 14,000

2 14,000

3 14,000

4 14,000

5 14,000

Sum of PVs = IRRA =

= NPV at r = 10%. NPV = 0, so IRR = 19,9%. =IRR(B90:F90) using IRR function 1 28,000 2 12,000 3 10,000 4 10,000 5 10,000

Year = Project B
IRRB =

=IRR(B100:F100) using IRR function

The IRR method of capital budgeting maintains that projects should be accepted if their IRR is greater than the cost of capital. Strict adherence to the IRR method would further dictate that mutually exclusive 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, the projects are mutually exclusive, we would choose Project A 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 and the IRR methods for ranking Projects S and L.

MULTIPLE IRRS (Section 10.4)

A 209 210 211 212 213 214 215 216 217 218 219 220 221 222 223 224 225 226 227 228 229 230 231 232 233 234 235 236 237 238 239 240 241 242 243 244 245 246 247 248 249 250 251 252 253 254 255 256 257 258 259 260 261 262 263

Because of the mathematics involved, it is possible for some (but not all) projects that have more than one change of signs in the cash flows to have more than one IRR. If you attempted to find the IRR with such a project using a financial calculator, you would get an error message. The HP-10B says "Error - Soln", the HP-17B says '"Many/No Solutions, and the HP12C says Error 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 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. However, the nature of the mathematics creates a scenario in which one IRR is quite extraordinary (often, several hundred percent).

Figure 10-4. Graph for Multiple IRRs: Project M (Millions of Dollars)

Year = Project M r =
NPV (Millions)

0 -1.60

1 10

2 -10

10%

NPV =

-$0.774

NPV = $1.6 + $10/(1+r) + ($10)/(1+r)2

$0.70

IRR #1 = 25%

IRR #2 = 400%

0%

100%

200%

300%

400%

500%

-$0.30 Cost of Capital (%)

Note: The table shown below calculates Project M's NPV at the rates shown in the left column. These data are plotted to form the graph shown above. Notice that NPV = 0 at both 25% and 400%. Since the definition of the IRR is the rate at which the NPV = 0, there are two IRRs. r 0% 10% 25% 110% 400% 500% NPV -$1.600 -$0.774 $0.000 $0.894 $0.000 -$0.211

= IRR #1 = 25% = IRR #2 = 400%

REINVESTMENT RATE ASSUMPTIONS (Section 10.5)

A 264 265 266 267 268 269 270 271 272 273 274 275 276 277 278 279 280 281 282 283 284 285 286 287 288 289 290 291 292 293 294 295 296 297

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. MODIFIED INTERNAL RATE OF RETURN, MIRR (Section 10.6) The modified internal rate of return is the discount rate that causes a project's cost (or cash outflows) to equal the present value of the project's terminal value. The terminal value is defined as the sum of the future values of the project's cash inflows, compounded at the project's cost of capital. To find MIRR, calculate the PV of the outflows and the FV of the inflows, and then find the rate that equates the two. Alternatively, you can solve using Excel's MIRR function.

One advantage of using the MIRR, relative to the IRR, is that the MIRR assumes that cash flows received are reinvested at the cost of capital, not the IRR. Since reinvestment at the cost of capital is more likely, the MIRR is a better indicator of a project's profitability. Moreover, it solves the multiple IRR problem, as a set of cash flows can have but one MIRR. Also, note that Excel's MIRR function allows for discounting and reinvestment to occur at different rates. Generally, MIRR is defined as reinvestment at the WACC, though Excel allows the calculation of MIRR where reinvestment is likely to occur at a different rate than WACC. 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, that the actual reinvestment rate will be the cost of capital than the IRR, especially if the IRR is quite high. The MIRR setup can be used to prove that NPV indeed does assume reinvestment at the WACC and IRR at the IRR. If negative cash flows occur in years beyond Year 1, those cash flows should be discounted at the cost of capital and added to the Year 0 cost to find the total PV of costs. If both positive and negative flows occurred in a given year, the negative flows should be discounted, and the positive ones compounded, rather than just dealing with the net cash flow. This can make a difference.

298 Figure 10-5. Finding the MIRR for Projects S and L 299 300 r = 10% 301 Year = 302 0 (r = 10%) 1 2 3 303 Project A -42,000 14,000 14,000 14,000 304 305 306 307 -42,000 Terminal Value (TV) = 308 309 Calculator: N = 4, PV = -10000, PMT = 0, FV = 15795. Press I/YR to get: =RATE(F208,0,B209,F213) 310 Excel Rate function--Easier: 311 Excel MIRR function--Easiest: =MIRR(B209:F209,B206,B206) 312 Year = 313 0 (r = 10%) 1 314 Project B -45,000 28,000 315 316 For Project B, using the MIRR function: 2
12,000

4
14,000 $15,400 $16,940 $18,634 $64,974 MIRRS = MIRRS = MIRRS = 11.53% 11.53% 11.53%

3
10,000

4
10,000 MIRRL = 12.77%

=MIRR(B220:F220,B206,B206) =

A B C D E F G H 317 318 Notes: 319 1. In Figure 10-5 we find the discount rate that forces the present value of the terminal value to equal the project's cost. That discount rate is defined as the MIRR. 320 N 4 321 $10,000 =TV/(1+MIRR) = $15,795/(1+MIRR) . We can find the MIRR with a 322 calculator or Excel. 323 2. If S and L are independent, both should be accepted as both MIRRs exceed the cost of capital. If they are mutually exclusive, then L should be chosen because it has the higher MIRR. 324 325 326 327 328 NPV PROFILES (Section 10.7) 329 330 An NPV profile shows how a project's NPV declines as the WACC used to calculate the NPV increases. Figure 10-4, for the 331 multiple IRR example, shows a NPV profile. Normally, though, the cash flows change sign only once--a negative for the 332 Time = 0 cash flow and then positive cash flows thereafter, so normally NPV profiles look like the one in Figure 10-6. 333 334 335 336 Figure 10-6. NPV Profile for Project A 337 338 Cost of capital = 10.00% 0 1 2 3 4 Year = 339 340 Project A -42,000.00 14,000 14,000 14,000 14,000 341 NPVS 342 r 343 0% $14,000.00 344 5% 7,643.31 345 10% 2,378.12 346 14.489% -1,613.46 NPV = $0, so IRR = 14.489% 347 15% -2,030.30 348 20% -5,757.72 349 350 PROJECT S's NPV PROFILE Net Present 351 Value for S 352 353 354 355 356 357 $2,000 358 NPVS = 0, so IRR = 14.489% 359 360 361 362 363 364 365 366 0% 5% 10% 15% 20% 367 368 Cost of Capital (%) 369 370 -$1,000 371 372 373

A 374 375 376 377 378 379 380 381 382 383 384 385 386 387 388 389 390

The Crossover Rate The crossover rate is the rate at which the NPV of Project A is equal to the NPV of Project B. The easiest way to find the crossover rate is to subtract one project's cash flows from the others and find the IRR of this differential cash flow stream.

Year = Project A Project B D = CFS CFL

0 -$42,000 -45,000 $3,000

1 $14,000 28,000 -$14,000

2 $14,000 12,000 $2,000

3 $14,000 10,000 $4,000

4 $14,000 10,000 $4,000

IRR D = -4.772%

A 391 392 393 394 395 396 397 398 399 400 401 402 403 404 405 406 407 408 409 410 411 412 413 414 415 416 417 418 419 420 421 422 423 424 425 426 427 428 429 430 431 432 433 434 435 436 437 438 439 440 441 442 443 444 445 446 447

Figure 10-7. NPV Profiles for Projects S and L: Shows Why Conflict Occurs
Cost of Capital 0% 5% 10% 11.975% 13.549% 14.489% 20% NPVS $14,000.00 7,643.31 2,378.12 545.49 -828.16 -1,613.46 -$5,757.72 NPVL $15,000.00 9,416.42 4,715.18 3,059.79 NPVS = NPVL 1,811.80 NPVL = 0 1,095.41 NPVS = 0 -$2,723.77

Crossover = IRRL = IRRS =

$5,000

NPV

L
$4,000

$3,000

S
At WACC: NPVL > NPVS

Crossover: Conflict if WACC is to left of crossover, no conflict if WACC is to right. Since WACC = 10%, which is left of the crossover rate, there IS a conflict: NPVL > NPVS, but IRRS > IRRL.

$2,000

$1,000

NPVS at WACC
$0 0% 10%

IRRS > IRRL

20%

Cost of Capital30%

-$1,000

IRRL

-$2,000

CONCLUSIONS ON CAPITAL BUDGETING METHODS (Section 10.10) NPV is the single best criterion because it provides a direct measure of the value a project adds to shareholder wealth. However, all methods provide helpful information. DECISION CRITERIA USED IN PRACTICE (Section 10.11) NPV and IRR are the most widely used methods.

A 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 37 38 39 40 41 42 43

In this file we use Excel to do most of the calculations explained in the textbook. First, we analyze Projects S and L, 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 the time line format because rows can be added and we can set the problem up as a series of income statements. For long problems, it is often more convenient to use a vertical layout.

Figure 10-1. Net Cash Flows (CFt) and Selected Evaluation Criteria for Projects S and L Panel A: Project Cash Flows and Cost of Capital
Project cost of capital, r, for each project: Initial Cost Project S Project L
0 -$10,000 -$10,000 10%

After-Tax, End of Year, Project Cash Flows, CFt

1 $5,000 $1,000 2 $4,000 $3,000 3 $3,000 $4,000 4 $1,000 $6,750

Panel B: Summary of Selected Evaluation Criteria

Project S $788.20 14.49% 12.11% 1.08 2.95 Project L $1,004.03 13.55% 12.66% 1.10 3.30 3.78

NPV IRR MIRR PI Payback Discounted Payback

A 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99

Figure 10-9. Payback Period

Years = Cash flow Cumulative cash flow Intermediate calculation for payback 0 -10,000 -10,000 1 5,000 -5,000 2 4,000 -1,000 3 3,000 2,000 2.33 4 1,000 3,000 5.00

Project S

Intermediate calculation:

Manual calculation of Payback S = 2 + $1,000/$3,000 = Excel calculation of Payback S = Years Cash flow Cumulative cash flow 0 -10,000 -10,000

2.33 2.33 1 1,000 -9,000 3.30 3.30

=IF(F388>0,E386+ABS(E388/F387),"-") 2.33 2 3,000 -6,000 3 4,000 -2,000 4 6,750 4,750

Project L

Manual calculation of Payback L = 3 + $2,000/$6,750 = Alternative Excel calculation of Payback L = =PERCENTRANK(C397:G397,0,6)*G395 =

Payback is between negative and positive cumulative cash flow.

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 value of money. This second problem is addressed with the discounted payback as discussed below, but the failure to consider beyond-payback cash flows is a problem for both payback methods.

Figure 10-10. Discounted Payback

WACC = 10%

Project S

Years = Cash flow Discounted cash flow Cumulative discounted CF

0 -10,000.00 -10,000.00 -10,000.00

1 5,000.00 4,545.45 -5,454.55 2.95 2.95 1 1,000.00 909.09 -9,090.91 3.78 3.78

2 4,000.00 3,305.79 -2,148.76

3 3,000.00 2,253.94 105.18

4 1,000.00 683.01 788.20

Discounted Payback S = 2 + $2,148.76/$2,253.94 = Excel calculation of Discounted Payback S = =PERCENTRANK(C418:G418,0,6)*G415 = Years Cash flow Discounted cash flow Cumulative discounted CF 0 -10,000.00 -10,000.00 -10,000.00

Payback is between negative and positive cumulative discounted cash flow.

Project L

2 3,000.00 2,479.34 -6,611.57

3 4,000.00 3,005.26 -3,606.31

4 6,750.00 4,610.34 1,004.03

Discounted Payback L = 3 + $3,606.31/$4,610.34 = Excel calculation of Discounted Payback L = =PERCENTRANK(C427:G427,0,6)*G424 =

Payback is between negative and positive cumulative discounted cash flow.

Figure 10-2. Finding the NPV for Projects S and L

To calculate the NPV, we find the present value of the individual cash flows and then sum those discounted cash flows. The sum is the value the project adds to or subtracts from shareholder wealth.

A B the present value C of the individual D E and then sum F those discounted G H To calculate the NPV, we find cash flows cash flows. 100 The sum is the value the project adds to or subtracts from shareholder wealth. 101 r = 10% 102 103 Year = 104 0 (r = 10%) 1 2 3 4 Project S 105 -10,000.00 5,000 4,000 3,000 1,000 106 4,545.45 107 3,305.79 108 2,253.94 109 683.01 NPV = $788.20 Long way: Sum the PVs of the CFs to find NPV 110 S 111 112 113 114 115 116 117 118 119 120 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149 150 NPVL = $1,004.03 Short way: Use Excel' s NPV function
=NPV(B51,C62:F62)+B62

Year = Project L

0 (r = 10%) -10,000.00

1 1,000

2 3,000

3 4,000

4 6,750

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 all respects. If strictly using the NPV method to evaluate two mutually exclusive projects, you would want to accept the project that adds the most value (i.e. the project with the higher positive NPV). Hence, if considering the above two projects, you would accept both projects if they are independent, and you would only accept Project L if they are mutually exclusive.

INTERNAL RATE OF RETURN (IRR) (Section 10.3)

The internal rate of return is defined as the discount rate that equates the present value of a project's cash inflows to its outflows. In other words, the internal rate of return is the interest rate that forces NPV to zero. The calculation for IRR can be tedious, but Excel provides an IRR function that merely requires 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.

Figure 10-3. Finding the IRR

r = 14.49% Year = Project S
0 -10,000.00 4,367.24 3,051.64 1,999.09 582.03 $0.00 14.49% 0 1 5,000 2 4,000 3 3,000 4 1,000

Sum of PVs = IRRS =

= NPV at r = 14.489%. NPV = 0, so IRR = 14.489%. =IRR(B90:F90) using IRR function 1 2 3 4

Year =

151 152 153 154 155 156 157 158 159 160 161 162 163 164 165

A Project L
IRRL =

B
-10,000.00 13.55%

C
1,000

D
3,000

E
4,000

F
6,750

=IRR(B100:F100) using IRR function

The IRR method of capital budgeting maintains that projects should be accepted if their IRR is greater than the cost of capital. Strict adherence to the IRR method would further dictate that mutually exclusive 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, 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 and the IRR methods for ranking Projects S and L.

MULTIPLE IRRS (Section 10.4)

A 166 167 168 169 170 171 172 173 174 175 176 177 178 179 180 181 182 183 184 185 186 187 188 189 190 191 192 193 194 195 196 197 198 199 200 201 202 203 204 205 206 207 208 209 210 211 212 213 214 215 216 217 218 219 220

Because of the mathematics involved, it is possible for some (but not all) projects that have more than one change of signs in the cash flows to have more than one IRR. If you attempted to find the IRR with such a project using a financial calculator, you would get an error message. The HP-10B says "Error - Soln", the HP-17B says '"Many/No Solutions, and the HP12C says Error 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 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. However, the nature of the mathematics creates a scenario in which one IRR is quite extraordinary (often, several hundred percent).

Figure 10-4. Graph for Multiple IRRs: Project M (Millions of Dollars)

Year = Project M r =
NPV (Millions)

0 -1.60

1 10

2 -10

10%

NPV =

-$0.774

NPV = $1.6 + $10/(1+r) + ($10)/(1+r)2

$0.70

IRR #1 = 25%

IRR #2 = 400%

0%

100%

200%

300%

400%

500%

-$0.30 Cost of Capital (%)

Note: The table shown below calculates Project M's NPV at the rates shown in the left column. These data are plotted to form the graph shown above. Notice that NPV = 0 at both 25% and 400%. Since the definition of the IRR is the rate at which the NPV = 0, there are two IRRs. r 0% 10% 25% 110% 400% 500% NPV -$1.600 -$0.774 $0.000 $0.894 $0.000 -$0.211

= IRR #1 = 25% = IRR #2 = 400%

REINVESTMENT RATE ASSUMPTIONS (Section 10.5)

A 221 222 223 224 225 226 227 228 229 230 231 232 233 234 235 236 237 238 239 240 241 242 243 244 245 246 247 248 249 250 251 252 253 254

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. MODIFIED INTERNAL RATE OF RETURN, MIRR (Section 10.6) The modified internal rate of return is the discount rate that causes a project's cost (or cash outflows) to equal the present value of the project's terminal value. The terminal value is defined as the sum of the future values of the project's cash inflows, compounded at the project's cost of capital. To find MIRR, calculate the PV of the outflows and the FV of the inflows, and then find the rate that equates the two. Alternatively, you can solve using Excel's MIRR function. One advantage of using the MIRR, relative to the IRR, is that the MIRR assumes that cash flows received are reinvested at the cost of capital, not the IRR. Since reinvestment at the cost of capital is more likely, the MIRR is a better indicator of a project's profitability. Moreover, it solves the multiple IRR problem, as a set of cash flows can have but one MIRR. Also, note that Excel's MIRR function allows for discounting and reinvestment to occur at different rates. Generally, MIRR is defined as reinvestment at the WACC, though Excel allows the calculation of MIRR where reinvestment is likely to occur at a different rate than WACC. 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, that the actual reinvestment rate will be the cost of capital than the IRR, especially if the IRR is quite high. The MIRR setup can be used to prove that NPV indeed does assume reinvestment at the WACC and IRR at the IRR. If negative cash flows occur in years beyond Year 1, those cash flows should be discounted at the cost of capital and added to the Year 0 cost to find the total PV of costs. If both positive and negative flows occurred in a given year, the negative flows should be discounted, and the positive ones compounded, rather than just dealing with the net cash flow. This can make a difference.

255 Figure 10-5. Finding the MIRR for Projects S and L 256 257 r = 10% 258 Year = 259 0 (r = 10%) 1 2 3 Project S 260 -10,000 5,000 4,000 3,000 261 262 263 264 -10,000 Terminal Value (TV) = 265 266 Calculator: N = 4, PV = -10000, PMT = 0, FV = 15795. Press I/YR to get: =RATE(F208,0,B209,F213) 267 Excel Rate function--Easier: 268 Excel MIRR function--Easiest: 269 Year = 270 0 (r = 10%) Project L 271 -10,000 272 273 For Project L, using the MIRR function:
=MIRR(B209:F209,B206,B206)

4
1,000 $3,300 $4,840 $6,655 $15,795 MIRRS = MIRRS = MIRRS = 12.11% 12.11% 12.11%

1
1,000

2
3,000

3
4,000

4
6,750 MIRRL = 12.66%

=MIRR(B220:F220,B206,B206) =

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Notes: 1. In Figure 10-5 we find the discount rate that forces the present value of the terminal value to equal the project's cost. That discount rate is defined as the MIRR. N 4 $10,000 =TV/(1+MIRR) = $15,795/(1+MIRR) . We can find the MIRR with a calculator or Excel. 2. If S and L are independent, both should be accepted as both MIRRs exceed the cost of capital. If they are mutually exclusive, then L should be chosen because it has the higher MIRR.

NPV PROFILES (Section 10.7) An NPV profile shows how a project's NPV declines as the WACC used to calculate the NPV increases. Figure 10-4, for the multiple IRR example, shows a NPV profile. Normally, though, the cash flows change sign only once--a negative for the Time = 0 cash flow and then positive cash flows thereafter, so normally NPV profiles look like the one in Figure 10-6.

Figure 10-6. NPV Profile for Project S

Cost of capital = 10.00%

Year = Project S

0 -10,000.00 r 0% 5% 10% 14.489% 15% 20%

1 5,000

2 4,000

3 3,000

4 1,000

NPVS $3,000.00 1,804.24 788.20 0.00 NPV = $0, so IRR = 14.489% -83.30 -837.19
PROJECT S's NPV PROFILE

Net Present Value for S

$2,000 NPVS = 0, so IRR = 14.489%

0%

5%

10%

15%

20%

Cost of Capital (%) -$1,000

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The Crossover Rate 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 the crossover rate is to subtract one project's cash flows from the others and find the IRR of this differential cash flow stream. Year = Project S Project L D = CFS CFL
0 -$10,000 -10,000 $0 1 $5,000 1,000 $4,000 2 $4,000 3,000 $1,000 3 $3,000 4,000 -$1,000 4 $1,000 6,750 -$5,750

IRR D = 11.975%

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Figure 10-7. NPV Profiles for Projects S and L: Shows Why Conflict Occurs
Cost of Capital 0% 5% 10% 11.975% 13.549% 14.489% 20% NPVS $3,000.00 1,804.24 788.20 428.38 156.40 0.00 -$837.19 NPVL $4,750.00 2,682.06 1,004.03 428.38 NPVS = NPVL 0.00 NPVL = 0 -243.65 NPVS = 0 -$1,513.31

Crossover = IRRL = IRRS =

$5,000

NPV

L
$4,000

$3,000

S
At WACC: NPVL > NPVS

Crossover: Conflict if WACC is to left of crossover, no conflict if WACC is to right. Since WACC = 10%, which is left of the crossover rate, there IS a conflict: NPVL > NPVS, but IRRS > IRRL.

$2,000

$1,000

NPVS at WACC
$0 0% 10%

IRRS > IRRL

20%

Cost of Capital 30%

-$1,000

IRRL

-$2,000

PROFITABILITY INDEX (PI) (Section 10.8) 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.

Figure 10-8. Profitability Index (PI) Project S: PIS = PV of future cash flows Initial cost PIS = $10,788.20 $10,000 PIS = 1.0788

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PIL = PV of future cash flows Initial cost PIL = $11,004.03 $10,000 PIL = 1.1004

Notes: 1. If Projects L and S are independent, both should be accepted as both have PI greater than 1.0. However, if they are mutually exclusive, Project L should be chosen as it has the higher PI. 2. PI and NPV rankings will be consistent if the projects have the same cost, as is true for S and L. However, if they differ in size, conflicts can occur. In the event of a conflict, the NPV ranking should be used.

PAYBACK PERIOD (Section 10.9) The payback period is defined as the expected number of years required to recover the investment, and it was the 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 the unrecovered balance at the end of that year divided by the following year's cash flow. Generally speaking, the shorter the payback period, the better the investment.

It's easy to calculate the payback manually--calculate cumulative cash flows and look to see when the cumulative 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 many paybacks or if you wanted to do sensitivity analysis for a given project, but this is more complicated. You can see the formula below, and the procedure is explained in detail in our Excel Tutorial. We use the formula only if we must do a number of payback calculations--for just one or two, the manual approach is much easier.

CONCLUSIONS ON CAPITAL BUDGETING METHODS (Section 10.10) NPV is the single best criterion because it provides a direct measure of the value a project adds to shareholder wealth. However, all methods provide helpful information. DECISION CRITERIA USED IN PRACTICE (Section 10.11) NPV and IRR are the most widely used methods.