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3/17/03

Part 1. Worksheet for Chapter 11, Capital Budgeting

We go through this model, using the data for Projects S and L as shown below, to calculate Payback, Discounted
Payback, NPV, IRR, MIRR, and PI. The model also goes into conflicts between NPV and IRR, multiple IRRs, and
unequal project lives. As such, it deals with most of the BOC questions.

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Year
0
1
2
3
4

Expected A-T Net CF


Project S
Project L
-$10,000
-$10,000
5,000
1,000
4,000
3,000
3,000
4,000
1,000
6,000

Risk-adjusted WACC:
Reinvestment rate:

10.00%
10.00%

Payback : The payback is easy to determine just by looking at the cumulative cash flows from a project, but it is a bit
tricky to calculate with Excel. However, the Excel exercise is useful as a way of learning something about Excel's logical
functions, so we explain it in the worksheet named "Payback." Click the tab labeled Payback to see the explanation.

Note, though, that the Excel payback calculation can be omitted without loss of continuity.
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Project S

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Discounted Payback

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Project S

Cash flow:
Cumulative cash flow:
Payback:
2.33
Project L
Cash flow:
Cumulative cash flow:
Payback:
3.33

Cash flow:
Discounted CF:
Cumulative cash flow:
Payback:
Project L (Alternative calc)
Cash flow:
Discounted CF:
Cumulative cash flow:
Payback:
0.00

0
-10,000
-10,000
0
-10,000
-10,000

0
-10,000
-10000
-10,000
0
-10,000
-10,000
-10,000

5,000
-5,000

4,000
-1,000

3,000
2,000
2.33

1
1,000
-9,000

2
3,000
-6,000

3
4,000
-2,000

1,000 From above


3,000 Calculated in
Payback worksheet
4
6,000 From above
4,000 See payback
3.33
worksheet
4

5,000
4545
-5,455

4,000
3306
-2,149

3,000
2254
105
2.95

1,000 From above


683 See payback
788
worksheet

1
1,000
909
-9,091

2
3,000
2,479
-6,612

3
4,000
3,005
-3,606

4
6,000 From above
4,098
492 See payback
3.88
worksheet

NPV and IRR


Project S
Cash flow:
NPVS
IRRS

0
-10,000
$788.20
14.49%

Project L (Alternative calc)


Cash flow:
NPVL
IRRL

0
-10,000
$491.77
11.79%

2
5,000

3
4,000

4
3,000

1,000

formulas used:
=NPV(G4,D40:G40)+C40

=IRR(C40:G40)
1
1,000

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2
3,000

3
4,000

4
6,000

Copyright (c) 2002 by Harcourt, Inc.

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NPV
S

5%
7.17%

$1,804

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11.79%

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14.49%

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15%

10%

$5,000

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We can use the Data Table procedure to calculate NPV for the two projects at different costs of capital, and then
graph the data to create NPV profiles.

$3,000

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NPV Profile Graph

0%

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The IRR function assumes that the first cash flow in the specified range is the investment at Year 0, so we can just
use the IRR function. Click fx > Financial > IRR > OK, and then specify the range C40:G40. You could make a guess
as to the IRR, but that is not necessary except where multiple IRRs occur. We discuss multiple IRR later in the
spreadsheet.

$788

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Note that Excel's NPV function assumes that the first payment occurs at the end of the first year. In fact, the
investment is made at the beginning of the period. Therefore, we proceed as follows: Click fx > Financial > NPV >
OK to get the NPV dialog box. Then specify the cell where WACC is first entered, G4, and specify the range of cash
flows as going from Year 1 through Year 4, D40:G40. Click OK to get the PV of the positive flows. Then edit the
formula by adding the initial cost to get the NPV.

WACC

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$1,344

$788
$461
$0
-$83

$4,000

$492

$4,000
$2,065

NPVL is

Larger
$1,344 Crossover
$492
$0

IRRL

-$680

IRRS

$3,000

$2,000
$1,000
$0
($1,000)
-1% 1%

-$801

3%

5%

7%

9% 11% 13% 15%

We can use Goal Seek to find the crossover rate. First, copy the NPV's to cells C67 and C68 as shown below, and
subtract L from S. Now what we want to do is find the WACC in G4 that forces L to equal S, which means that the
difference as shown in C69 will be zero. Put the pointer on C69 and then Click Tools > Goal Seek. Then specify that
C69 is to be set equal to 0 by changing G4, the cell where the WACC first enters the model. When you click OK, G3 will
change to 7.17..., and this is the crossover rate. Record that number and then enter 10% in G4 to restore the
spreadsheet to its original inputs.
NPVS
NPVL
NPVS - NPVL

$788.20
$491.77
$296.43

7.17% = Crossover rate.

MIRR
The regular IRR finds the discount rate that causes the sum of the discounted cash flows to equal 0. The modified IRR
first compounds all cash flows the the end of the project's life (generally but not necessarily at the WACC), sums the
compounded cash flows to form the "Terminal Value," and then finds the discount rate that causes the PV of the TV to
equal the cost of the project.
Excel has a built in MIRR function that can be accessed as follows: fx > Financial > MIRR > OK. Then, in the
dialog box, insert the range of values for the investment's cost and cash inflows, insert the WACC as the "financing
rate," and insert some assumed reinvestment rate, which normally should be the WACC for reasons explained in the
text. Of course, if some other reinvestment rate is more appropriate, insert it.
Regular IRR
MIRR
ProjectS
14.49%
12.11% The MIRR shows the rate of return the company would actually earn on the
ProjectL
11.79%
11.33% project if the cash flows can be reinvested at the WACC. If this reinvestment
rate assumption is correct, then the regular IRR overstates the true return.

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Copyright (c) 2002 by Harcourt, Inc.

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For this reason, the MIRR is often considered to be the "better" IRR.
If the IRR happens to equal the WACC, then the IRR and the MIRR will be
equal. Otherwise, they will be different.

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Copyright (c) 2002 by Harcourt, Inc.

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Here is a data table that calculates the Regular IRR and MIRR for S and L at different reinvestment rates (or WACCs):
Project S
Project L
19.0%
WACC
Reg IRR
Reg
IRR
MIRR
MIRR
17.0%
MIRR-S
14.5%
12.1%
11.8%
11.3%
15.0%
MIRR-L
0%
14.5%
6.8%
11.8%
8.8%
13.0%
5%
14.5%
9.4%
11.8%
10.0%
11.0%
7.17%
14.5%
10.6%
11.8%
10.6%
9.0%
10%
14.5%
12.1%
11.8%
11.3%
7.0%
11.8%
14.5%
13.1%
11.8%
11.8%
5.0%
14.5%
14.5%
14.5%
11.8%
12.5%
0%
5%
10%
15%
20%
15%
14.5%
14.8%
11.8%
12.6%
WACC
20%
14.5%
17.4%
11.8%
13.9%
The data table demonstrates these points:
1. IRR and MIRR for a project are equal if IRR = WACC. See WACC = 11.8%.
MIRR

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2. IRR is independent of WACC, but MIRR increases with the WACC. See IRR and MIRR columns.
3. There can be ranking conflicts between projects based on the MIRR. At WACC's below 7.17%, the crossover rate,
MIRRL > MIRRS, but at WACCs above 7.17%, MIRRS > MIRRL.

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Profitability Index (PI), sometimes called the Benefit/Cost Ratio

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This criterion shows the PV of benefits (inflows) per dollar of investment cost. If it takes several years to build a
project, then we would find the PV of the costs. Costs and benefits are both discounted at the WACC. Here are the PI's
for Projects S and L:

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PIS:
=
PV Inflows
/
PV Cost
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=
$10,788
$10,000
100
=
1.08
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PIL:
=
PV Inflows
/
PV Cost
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=
$10,492
$10,000
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=
1.05
105
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107 The PV of S's inflows exceeds its cost by about 8%, whereas L's benefits are about 5% larger than its cost.
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MIRRS
MIRRL
Assumed
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Reinv. Rate
12.11%
11.33%
This data table shows that MIRR rankings can conflict
110
8.78%
0.00%
depending on the reinvestment rate.
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6.78%
10.05%
5.00%
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9.45%
7.17%
10.60%
10.60%
This data table shows that MIRR does not depend on WACC:
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MIRRS
MIRRL
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12.11%
10.00%
11.33%
12.81%
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11.33%
WACC
12.11%
11.33%
11.67%
13.06%
11.79%
0%
12.11%
11.33%
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11.79%
13.22%
12.11%
5%
12.11%
11.33%
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11.87%
14.49%
14.49%
10%
12.11%
11.33%
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12.49%
14.76%
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15.00%
15%
12.11%
11.33%
12.62%
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Copyright (c) 2002 by Harcourt, Inc.

We have seen that conficts can exist between the NPV and IRR for Projects S and L, depending on the WACC. S's IRR
121 is always higher than that of L (14.49% vs. 11.79%), but L's NPV and MIRR are above those of S if the WACC is below
the 7.17% crossover rate. Similar conflicts could be found with the PI.
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The reason for the conflicts is the reinvestment rate assumptions built into the NPV and IRR. NPV assumes
reinvestment at the WACC, and IRR assumes reinvestment at the IRR itself.

The condition that caused the conflict was the differing timing of the cash flows for S and L. However, conflicts
123 could also arise if the timing patterns were the same but the sizes of the two projects differed. The following example
demonstrates this point.
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Expected after-tax
125
net
cash flows (CFt)
126
NPV Big
$788 Big is the winner by NPV
Year
Big
Little
NPV Little
$162
127
0
-$10,000
-$1,000
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1
5,000
600
IRR Big
14.5%
129
2
4,000
300
IRR Little
19.2% Little is the winner by IRR
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3
3,000
400
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4
1,000
100
So we have a NPV vs. IRR conflict due to size. You could use
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Goal Seek to learn that the crossover rate for these two
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projects is 13.96%. If WACC is above 13.96%, Little is better
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by both the NPV and the IRR criteria.
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136

Multiple IRRs

Multiple IRR can exist if a project has non-normal cash flows, i.e., where the sign of the flows changes more than once.
137 The most common situation is where there is a negative cash flow at t = 0, then a stream of positive CF's, and then a
negative CF at the end of the project's life. The follwing example is of this type.
138
Year
Project M
WACC
10.0%
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0
-$2,000
NPV
-$715.25
Regular NPV formula
"Guess" takes
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IRR1
1
1,000
23%
IRR formula with guess of 10%
us to
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IRR
2
5,000
72%
IRR formula with guess of 100%
closest IRR.
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2
3
5,000
MIRR
7.9%
MIRR function with WACC and reinvestment = 10%
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4
-11,000
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145
400
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Data for IRR Graph
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200
-$715
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0
10%
-715
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0%
10% 20% 30% 40% 50% 60% 70% 80%
20%
-106
150
-200
30%
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151
40%
224
152
-400
50%
198
153
60%
120
-600
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70%
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155
-800
80%
-92
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There are two positive IRR's, but with WACC = 10%, the NPV is negative (at -$715), so the project should be rejected.
158 When you get into multiple IRR situations, you should disregard both of them and focus on the NPV. You could also
calculate the MIRR and compare it with the WACC. Here the MIRR < WACC, so reject.
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Copyright (c) 2002 by Harcourt, Inc.

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Unequal Lives
CF: Short
CF: Long
Regular NPV
Regular IRR
CF: Short

C
WACC:
0
1
-$10,000
$4,500
-$20,000
$5,000
S
$1,190.8
16.65%
0
-$10,000
-$10,000

Ext'nd NPVS

$2,085.53

L
$1,776.3
12.98%
1
$4,500

D
10.00%
2
$4,500
$5,000

3
$4,500
$5,000

$5,000

$5,000

$5,000

Here it looks like L is better by the NPV, but wait!


2
$4,500

3
$4,500
-$10,000
$4,500
$4,500
-$5,500
Here we see that NPVS exceeds NPVS.

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$4,500
$4,500

$4,500
$4,500

$4,500
$4,500

Copyright (c) 2002 by Harcourt, Inc.

Part 2. Payback Period & Discounted Payback

This worksheet deals more with Excel than with finance, so it can be skipped without loss of continuity. However, it
is useful to learn something about Excel's logical functions, as they come in handy quite often.

Project S

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5
6
7
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10
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12
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15
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Cash flow:
Cumulative cash flow:
Payback:

2.33

Project L (Alternative calc)


Cash flow:
Cumulative cash flow:

3/17/03

0
-10,000
-10,000
0
0.00

1
5,000
-5,000
0
0.00

2
4,000
-1,000
0
0.00

3
3,000
2,000
1
2.33

4
1,000 Basic cash flows
3,000 Simple formula
0
0.00 Logical If function. See below
for explanation.

0
-10000
-10000
0
0.00

1
1000
-9000
0
0.00

2
3000
-6000
0
0.00

3
4000
-2000
0
0.00

4
6000 Basic cash flows
4000 Simple formula
1 Logical If function. See below
3.33 for explanation.

Payback:
3.33
`
1. We want to identify when the investment is recovered. We can see, from the cumulative CFs for S, that recovery
occurs after Year 2 and before the end of Year 3, so the payback will be 2+ years i.e., during Year 3.

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2. We want Excel to find the year when cumulative CFs first become positive. The payback is equal to the prior
year plus a fraction, for Project S 2 + a fraction.

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3. We could use several procedures, but one way is to first use the LOGICAL "AND" function to find when the
year when the cumulative cash flow first becomes positive, as we do on Row 6, and then the LOGICAL "IF"
function to calculate the exact payback given that year.

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4. We show just below a picture of the filled-in dialog box for cell C6. First, we with the pointer on C6, we clicked
fx > LOGICAL > and > OK to open the box. We are looking for the situation where the cumulative cash flow first
becomes positive. This means that the prior year's CF is negative and this year's CF is positive., i.e., B5<0 and
C5>0. We used the AND Statement to determine if these conditions were met, and we copied that formula into cells
D6:G6. We got FALSE for all years except Year 3, so the payback is 3 plus a fraction.

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Copyright (c) 2002 by Harcourt, Inc.

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5. Next, in C7, we put in an IF statement that causes the payback to be shown if Row 6 shows TRUE and 0 if Row 6
shows FALSE. The first item specifies that the criterion is that F6=TRUE. If that condition does not hold, then 0 is
placed in C7. However if F6=TRUE, then the payback, is placed in C7. The payback formula is shown in the
second row of the dialog box, and it is equal to the number for the prior year plus the fraction of the current year
that it takes the year's cash flows to cover the prior year's negative cumulative cash flow: E5/F4. However, E5 is a
negative number, and to make the formula operate properly, we need to add the fraction. Otherwise, we get an
incorrect payback value. So, we need the absolute value (i.e., the positive) of the fraction. Excel gives the absolute
value for a cell by entering ABS(cell reference), e.g., ABS(E5/F4). The final result is the formula shown in the
second row of the dialog box. This formula is then copied into the other cells on Row 7.

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6. Once the payback has been calculated on row 7, we want to show it in Cell B7. We do that by putting the pointer
on cell B7 and then clicking fx > Statistical > MAX and then specifying the relevant range and clicking OK. That
puts the value 2.33 in cell B7.

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8. This same process is repeated to find Project L's payback.

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As we noted at the outset, in a simple problem such as this it is easier to calculate the payback
with a calculator than with Excel. However, if you were setting up a model to examine many
projects, the Excel approach would be superior. Also, Excel's logical functions are useful in
many situations, so it is helpful to learn how to use them.
Discounted Payback.

WACC =

10%

To find the discounted payback, find the PV of each cash flow, discounted at the WACC, and proceed as before.
Project S
Cash flow:
Discounted CF:
Cumulative cash flow:
Payback:
Project L (Alternative calc)
Cash flow:

0
-10,000
-10000
-10,000
0.00

1
5,000
4545
-5,455
0.00

2
4,000
3306
-2,149
0.00

3
3,000
2254
105
2.95

4
1,000 Basic cash flows
683
788 Simple formula
3.15 Logical If function used differently.
One less step.

0
-10,000

1
1,000

2
3,000

3
4,000

4
6,000 Basic cash flows

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Copyright (c) 2002 by Harcourt, Inc.

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B
Discounted CF:
Cumulative cash flow:
Payback:
-

C
-10,000
-10,000
0.00

D
909
-9,091
0.00

E
2,479
-6,612
0.00

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F
3,005
-3,606
0.00

G
H
I
4,098
492 Simple formula
3.88 Logical If function used differently.

Copyright (c) 2002 by Harcourt, Inc.

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