Topics
Reference
Simulator
Advisor Insights
Search Investopedia
Newsletters
CFA Level 1
By Investopedia
AAA |
You May Also Like: Learn to trade stocks with virtual money before you risk your own...
Chapter 1 - 5
Chapter 6 - 10
Chapter 11 - 15
Chapter 16 - 17
1. Ethics and Standards
2.6 Net Present Value and the Internal Rate of Return
2. Quantitative Methods
2.7 Money Vs. Time-Weighted Return
3. Microeconomics
2.8 Calculating Yield
4. Macroeconomics
2.9 Statistical Concepts And Market Returns
5. Global Economic Analysis
2.10 Basic Statistical Calculations
2.11 Standard Deviation And Variance
Quantitative Methods - Net Present Value and the
Internal Rate of Return
This section applies the techniques and formulas first presented in the time value of money material
toward real-world situations faced by financial analysts. Three topics are emphasized: (1) capital
budgeting decisions, (2) performance measurement and (3) U.S. Treasury-bill yields.
Net Preset Value
NPV and IRR are two methods for making capital-budget decisions, or choosing between alternate
Subscribe to the Financial Advisor
newsletter for the latest in practice
management
Enter e-mail address
See all newsletters
Sign Up
projects and investments when the goal is to increase the value of the enterprise and maximize
shareholder wealth. Defining the NPV method is simple: the present value of cash inflows minus the
present value of cash outflows, which arrives at a dollar amount that is the net benefit to the
organization.
To compute NPV and apply the NPV rule, the authors of the reference textbook define a five-step
process to be used in solving problems:
1.Identify all cash inflows and cash outflows.
1.Identify
2.Determine
2.
Determine an appropriate discount rate (r).
3.Use
3.
Use the discount rate to find the present value of all cash inflows and outflows.
4.Add
4.
Add together all present values. (From the section on cash flow additivity, we know that this action
is appropriate since the cash flows have been indexed to t = 0.)
5.Make
5.
Make a decision on the project or investment using the NPV rule: Say yes to a project if the NPV is
positive; say no if NPV is negative. As a tool for choosing among alternates, the NPV rule would
prefer the investment with the higher positive NPV.
HOT DEFINITIONS
Over-The-Counter - OTC
Quarter - Q1, Q2, Q3, Q4
Weighted Average Cost Of Capital - WACC
Basis Point (BPS)
Sharing Economy
Unlevered Beta
Companies often use the weighted average cost of capital, or WACC, as the appropriate discount rate
for capital projects. The WACC is a function of a firm's capital structure (common and preferred stock
and long-term debt) and the required rates of return for these securities. CFA exam problems will
either give the discount rate, or they may give a WACC.
Example:
To illustrate, assume we are asked to use the NPV approach to choose between two projects,
and our company's weighted average cost of capital (WACC) is 8%. Project A costs $7 million in
upfront costs, and will generate $3 million in annual income starting three years from now and
continuing for a five-year period (i.e. years 3 to 7). Project B costs $2.5 million upfront and $2
million in each of the next three years (years 1 to 3). It generates no annual income but will be
sold six years from now for a sales price of $16 million.
For each project, find NPV = (PV inflows) - (PV outflows).
Project A:
A: The present value of the outflows is equal to the current cost of $7 million. The
inflows can be viewed as an annuity with the first payment in three years, or an ordinary
annuity at t = 2 since ordinary annuities always start the first cash flow one period away.
Trading Center
Trading Center
PV annuity factor for r = .08, N = 5: (1 - (1/(1 + r)N)/r = (1 - (1/(1.08)5)/.08 = (1 - (1/(1.469328)/.08 =
(1 - (1/(1.469328)/.08 = (0.319417)/.08 = 3.99271
Multiplying by the annuity payment of $3 million, the value of the inflows at t = 2 is ($3
million)*(3.99271) = $11.978 million.
Discounting back two periods, PV inflows = ($11.978)/(1.08)2 = $10.269 million.
NPV (Project A) = ($10.269 million) - ($7 million) = $3.269 million.
Project B:
B: The inflow is the present value of a lump sum, the sales price in six years discounted
to the present: $16 million/(1.08)6 = $10.083 million.
million.
Cash outflow is the sum of the upfront cost and the discounted costs from years 1 to 3. We first
solve for the costs in years 1 to 3, which fit the definition of an annuity.
PV annuity factor for r = .08, N = 3: (1 - (1/(1.08)3)/.08 = (1 - (1/(1.259712)/.08 =
(0.206168)/.08 = 2.577097.
2.577097. PV of the annuity = ($2 million)*(2.577097) = $5.154 million.
PV of outflows = ($2.5 million) + ($5.154 million) = $7.654 million.
NPV of Project B = ($10.083 million) - ($7.654 million) = $2.429 million.
Applying the NPV rule, we choose Project A, which has the larger NPV: $3.269 million versus $2.429
million.
Exam Tips and Tricks
Problems on the CFA exam are frequently set up so that it is tempting to pick a choice that seems
intuitively better (i.e. by people who are guessing), but this is wrong by NPV rules. In the case we
used, Project B had lower costs upfront ($2.5 million versus $7 million) with a payoff of $16
million, which is more than the combined $15 million payoff of Project A. Don\'t rely on what feels
better; use the process to make the decision!
The Internal Rate of Return
The IRR, or internal rate of return,
return, is defined as the discount rate that makes NPV = 0. Like the NPV
Partner Links
Learn to trade stocks by investing $100,000 virtual
dollars...
Trade like a top hedge fund manager using technical
analysis and double your wealth...
Sign up for our daily newsletters
process, it starts by identifying all cash inflows and outflows. However, instead of relying on external
data (i.e. a discount rate), the IRR is purely a function of the inflows and outflows of that project. The
IRR rule states that projects or investments are accepted when the project's IRR exceeds a hurdle
rate. Depending on the application, the hurdle rate may be defined as the weighted average cost of
capital.
Example:
Suppose that a project costs $10 million today, and will provide a $15 million payoff three
years from now, we use the FV of a single-sum formula and solve for r to compute the IRR.
IRR = (FV/PV)1/N -1 = (15 million/10 million)1/3 - 1 = (1.5) 1/3 - 1 = (1.1447) - 1 = 0.1447, or 14.47%
In this case, as long as our hurdle rate is less than 14.47%, we green light the project.
NPV vs. IRR
Each of the two rules used for making capital-budgeting decisions has its strengths and weaknesses.
The NPV rule chooses a project in terms of net dollars or net financial impact on the company, so it
can be easier to use when allocating capital.
However, it requires an assumed discount rate, and also assumes that this percentage rate will be
stable over the life of the project, and that cash inflows can be reinvested at the same discount rate.
In the real world, those assumptions can break down, particularly in periods when interest rates are
fluctuating. The appeal of the IRR rule is that a discount rate need not be assumed, as the
worthiness of the investment is purely a function of the internal inflows and outflows of that
particular investment. However, IRR does not assess the financial impact on a firm; it only requires
meeting a minimum return rate.
The NPV and IRR methods can rank two projects differently, depending on thesize of the investment.
Consider the case presented below, with an NPV of 6%:
Project
Initial outflow
Payoff after one
year
IRR
NPV
$250,000
$280,000
12%
+$14,151
$50,000
$60,000
20%
+6604
By the NPV rule we choose Project A, and by the IRR rule we prefer B. How do we resolve the conflict
if we must choose one or the other? The convention is to use the NPV rule when the two methods
are inconsistent, as it better reflects our primary goal: to grow the financial wealth of the company.
Consequences of the IRR Method
In the previous section we demonstrated how smaller projects can have higher IRRs but will have
less of a financial impact. Timing of cash flows also affects the IRR method. Consider the example
below, on which initial investments are identical. Project A has a smaller payout and less of a
financial impact (lower NPV), but since it is received sooner, it has a higher IRR. When
inconsistencies arise, NPV is the preferred method. Assessing the financial impact is a more
meaningful indicator for a capital-budgeting decision.
Project
Investme
nt
Income in future periods
IRR
NPV
t1
t2
t3
t4
t5
$100k
$125k
$0
$0
$0
$0
25.0%
$17,925
$100k
$0
$0
$0
$0
$200k
14.9%
$49,452
Next: Money Vs. Time-Weighted Return
Compete, Risk Free with $100,000 in Virtual Cash
Put your trading skills to the test with our free Stock Simulator. Compete with thousands of
Investopedia traders and trade your way to the top! Submit trades in a virtual environment before
you start risking your own capital.
RELATED ARTICLES
INVESTING BASICS
Capital Budgeting: Capital Budgeting Decision Tools
Once projects have been identified, management then begins the financial
process of determining whether or not the project should be pursued. The three
common capital budgeting decision tools ...
PERSONAL FINANCE
An Introduction To Capital Budgeting
We look at three widely used valuation methods and figure out how companies
justify spending.
FUNDAMENTAL ANALYSIS
Calculating the Internal Rate of Return Using Excel
The internal rate of return on investments is explained and illustrated in different
investment scenarios.
FUNDAMENTAL ANALYSIS
Return on Investment (ROI) Vs. Internal Rate of Return (IRR)
Read about the similarities and differences between an investment's internal rate
of return (IRR) and its return on investment (ROI).
FUNDAMENTAL ANALYSIS
Internal Rate Of Return: An Inside Look
Use this method to choose which project or investment is right for you.
TERM
What is the Equivalent Annual Annuity Approach?
Companies use the equivalent annual annuity approach to compare the returns
of two projects that have different lifespans.
INSURANCE
How to Compare Permanent Life Insurance Policies
How you can use the internal rate of return to compare and purchase a
permanent life insurance policy.
INVESTING
Understanding The Discounted Payback Period
Its similar to a simple payback, but a discounted payback period accounts for
moneys time value. Its a more precise estimate of when investors will recover
their total investment.
FOREX EDUCATION
Time Value Of Money: Determining Your Future Worth
Determining monthly contributions to college funds, retirement plans or savings
is easy with this calculation.
FUNDAMENTAL ANALYSIS
Calculating the Present Value of an Annuity
The present value of an annuity is the current, lump sum value of periodic future
payments as calculated using a specific rate.
RELATED TERMS
Net Present Value - NPV
Internal Rate Of Return - IRR
Net Present Value Rule
IRR
Modified Internal Rate Of Return ...
Capital Budgeting
Net Present Value (NPV) is the difference
between the present ...
A rule stating that an investment should be
accepted if its net ...
While the internal rate of return (IRR) assumes
the cash flows ...
A metric used in capital budgeting measuring
the profitability ...
The currency abbreviation or currency symbol
for the Iranian ...
The process in which a business determines
whether projects such ...
RELATED FAQS
Q: How much debt is too much when calculating capital budgeting?
Learn how companies determine how much debt is acceptable when funding a new project by using the net
Learn how companies determine how much debt is acceptable when funding a new project by using the net
present value to estimate ... Read Answer >>
Q: How do you use discounted cash flow to calculate a capital budget?
Learn how discounted cash flows are used in creating capital budgets as a part of the net present value and
internal rate ... Read Answer >>
Q: What is the formula for calculating net present value (NPV) in Excel?
Understand how net present value is used to estimate the anticipated profitability of projects or investments and
how to ... Read Answer >>
Q: Do you discount working capital in net present value (NPV)?
Learn why changes in net working capital (NPV) should be included in net present value calculations for analyzing
a project's ... Read Answer >>
Q: What are the disadvantages of using net present value as an investment criterion?
While net present value (NPV) calculations are useful when you are valuing investment opportunities, the process
is by no ... Read Answer >>
Q: What's the difference between net present value and internal rate of return? How ...
Both of these measurements are primarily used in capital budgeting, the process by which companies determine
whether a new ... Read Answer >>
BROWSE BY TOPIC:
CFA
Cash Flow
Portfolio Management
Search Investopedia
DICTIONARY:
CONTENT LIBRARY
Articles
Terms
Symbol
CONNECT WITH INVESTOPEDIA
Videos
Guides
Slideshows
FAQs
Calculators
Chart Advisor
Stock Analysis
Stock Simulator
FXtrader
Exam Prep Quizzer
Net Worth Calculator
WORK WITH INVESTOPEDIA
About Us
Advertise With Us
2016, Investopedia, LLC.
GET FREE NEWSLETTERS
Write For Us
Contact Us
All Rights Reserved
Careers
Terms Of Use
Newsletters
Privacy Policy
