A B C D E F

12
13 In this file we use Excel to do most of the calculations explained in the textbook. First, we analyze Projects S
14
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 yea
15
generally use the time line format because rows can be added and we can set the problem up as a series of in
16
statements. For long problems, it is often more convenient to use a vertical layout.
17
18
19
20
21 Net Cash Flows (CFt) and Selected Evaluation Criteria for ProjectsA and B
22
23 Panel A: Project Cash Flows and Cost of Capital
24
25 Project cost of capital, r, for each project: 5%
26
27 Initial Cost After-Tax, End of Year, Project Cash Flows, CFt
28 0 1 2 3
29 Project A -$15,000 $5,000 $10,000 $20,000
30 Project B -$15,000 $20,000 $10,000 $6,000
31
32 Panel B: Summary of Selected Evaluation Criteria $6,750
33
34 Project A Project B
35 NPV $16,108.95 $18,300.94
36 IRR 43.97% 82.03%
37 MIRR 28.39% 36.98%
38 PI 2.07 2.22
39 Payback 0.75
40 Discounted Payback 2.15 0.83
41
42
43
44
45
46 Finding the NPV for Projects A and B
47
48 To calculate the NPV, we find the present value of the individual cash flows and then sum those discounted c
49 flows. The sum is the value the project adds to or subtracts from shareholder wealth.
50
51 r = 5%
52
53 Year = 0 1 2 3
54 Project A -15,000.00 5,000 10,000 20,000
 A B C D E F
55 4,761.90
56 9,070.29
57 17,276.75
58
59 NPVA= ### Long way: Sum the PVs of the CFs to find NPV
60
61 Year = 0 1 2 3
62 Project B -15,000.00 20,000 10,000 6,000
63
64 NPVB ### 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
this is that all such projects add wealth, and that should be the overall goal of the manager in all respects. I
69
strictly using the NPV method to evaluate two mutually exclusive projects, you would want to accept the pro
70
that adds the most value (i.e. the project with the higher positive NPV). Hence, if considering the above two
71
projects, you would accept both projects if they are independent, and you would only accept Project L if the
72 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 i
79 to its outflows. In other words, the internal rate of return is the interest rate that forces NPV to zero. The
80 calculation for IRR can be tedious, but Excel provides an IRR function that merely requires you to access th
81 function and enter the array of cash flows. The IRRs for Project S and L are shown below, along with the d
entry for Project S.
82
83
84
85
86 Finding the IRR
87
88 r = 14.49%
89 Year = 0 1 2 3
90 Project A -15,000.00 5,000 10,000 20,000
91 4,367.24
92 7,629.11
93 13,327.25
94
 A B C D E F
95 Sum of PVA = $10,323.59 = NPV at r = 14.489%. NPV = 0, so IRR = 14.489%.
96
97 IRRA = 43.97% =IRR(B90:F90) using IRR function
98
99 Year = 0 1 2 3 0
100 Project B -15,000.00 20,000 10,000 6,000 0
101
102 IRRB = 82.03% =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 than
107 cost of capital. Strict adherence to the IRR method would further dictate that mutually exclusive projects s
108
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 mut
109 exclusive, we would choose Project S because it has the higher IRR. Recall that this differs from our conclu
when using the NPV method. So, we have a conflict between the NPV and the IRR methods for ranking Pro
110 S and L.

111
112
113 MULTIPLE IRRS (Section 10.4)
114
 A B C D E F
115
Because of the mathematics involved, it is possible for some (but not all) projects that have more than one c
116 of signs in the cash flows to have more than one IRR. If you attempted to find the IRR with such a project u
117 financial calculator, you would get an error message. The HP-10B says "Error - Soln", the HP-17B says
118 '"Many/No Solutions, and the HP12C says Error 3; Key in Guess." The procedure for correcting the proble
119
to store in a guess for the IRR, and then the calculator will report the IRR that is closest to your guess. You
120 then use a different "guess" value, and you should be able to find the other IRR. However, the nature of th

121 mathematics creates a scenario in which one IRR is quite 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
129
130 r = 10% NPV = -$0.774
131
132 NPV
133 (Millions)
134
$0.90 NPV = −$1.6 + $10/(1+r) + (−$10)/(1+r)2
135
136
137 $0.70
138
139
$0.50
140
141
142 $0.30
143 IRR #1 = 25% IRR #2 = 400%
144
$0.10
145
146
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 for
155 graph shown above. Notice that NPV = 0 at both 25% and 400%. Since the definition of the IRR is the rate at which
156 NPV = 0, there are two IRRs.
157
158 r NPV
 A B C D E F
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
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
178 The modified internal rate of return is the discount rate that causes a project's cost (or cash outflows) to equal the pr
value of the project's terminal value. The terminal value is defined as the sum of the future values of the project's ca
179
inflows, compounded at the project's cost of capital. To find MIRR, calculate the PV of the outflows and the FV of th
180 inflows, and then find the rate that equates the two. Alternatively, you can solve using Excel's MIRR function.
181
182
183
184 One advantage of using the MIRR, relative to the IRR, is that the MIRR assumes that cash flows received are reinves
the cost of capital, not the IRR. Since reinvestment at the cost of capital is more likely, the MIRR is a better indicato
185
project's profitability. Moreover, it solves the multiple IRR problem, as a set of cash flows can have but one MIRR.
186
187
188 Also, note that Excel's MIRR function allows for discounting and reinvestment to occur at different rates. Generally,
189 MIRR is defined as reinvestment at the WACC, though Excel allows the calculation of MIRR where reinvestment is
190 to occur at a different rate than WACC.
191
192
193 As is stated in the text, NPV is superior to the IRR because (1) the NPV assumes that cash flows are reinvested at the
capital whereas the IRR assumes reinvestment at the IRR, and (2) it is more likely, in a competitive world, that the ac
194
reinvestment rate will be the cost of capital than the IRR, especially if the IRR is quite high. The MIRR setup can be
195 to prove that NPV indeed does assume reinvestment at the WACC and IRR at the IRR.
196
197
198 If negative cash flows occur in years beyond Year 1, those cash flows should be discounted at the cost of capital and a
199 the Year 0 cost to find the total PV of costs. If both positive and negative flows occurred in a given year, the negative
200 should be discounted, and the positive ones compounded, rather than just dealing with the net cash flow. This can m
201 difference.
 A B C D E F
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 -15,000 5,000 10,000 20,000 0
210 $22,000
211 $12,100
212 $6,655
213 -15,000 Terminal Value (TV) = $40,755
214
215 Calculator: N = 4, PV = -10000, PMT = 0, FV = 15795. Press I/YR to get: MIRRS =
216 Excel Rate function--Easier: =RATE(F208,0,B209,F213) MIRRS =
217 Excel MIRR function--Easiest: =MIRR(B209:F209,B206,B206) MIRRS =
218
219 Year = 0 (r = 10%) 1 2 3 4
220 Project L -15,000 20,000 10,000 6,000 0
221
222 For Project L, using the MIRR function: =MIRR(B220:F220,B206,B206) = MIRRL =
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)
235
236
237 An NPV profile shows how a project's NPV declines as the WACC used to calculate the NPV increases. Figure 10-4, f
multiple IRR example, shows a NPV profile. Normally, though, the cash flows change sign only once--a negative for t
238
Time = 0 cash flow and then positive cash flows thereafter, so normally NPV profiles look like the one in Figure 10-6.
239
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
246 Project S -15,000.00 5,000 10,000 20,000 0
247
248 r NPVS
249 0% $20,000.00
250 5% 16,108.95
251 10% 12,836.21
252 14.489% 10,323.59 NPV = $0, so IRR = 14.489%
253 15% 10,059.59
254 20% 7,685.19
255
256
257 Net Present Value for S PROJECT S's NPV PROFILE
258
259
260
261
262
263 $2,000 NPVS = 0, so IRR = 14.489%
264
265
266
267
268
269
270
271
272
273 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%
274
275 Cost of Capital (%)
276 -$1,000
277
278
279
280
281
282 The Crossover Rate
283
284
285 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
crossover rate is to subtract one project's cash flows from the others and find the IRR of this differential cash flow str
286
287
288
289 Year = 0 1 2 3 4
290 Project S -$15,000 $5,000 $10,000 $20,000 $0
291 Project L -15,000 20,000 10,000 6,000 0
292 D = CFS − CFL $0 -$15,000 $0 $14,000 $0
293
 A B C D E F
294 IRR D = -3.391%
295
296
 A B C D E F
297 Figure 10-7. NPV Profiles for Projects S and L: Shows Why Conflict Occurs
298
299 Cost of Capital NPVS NPVL
300 0% $20,000.00 $21,000.00
301 5% 16,108.95 18,300.94
302 10% 12,836.21 15,954.17
303 Crossover = 11.975% 11,686.05 15,110.26 NPVS = NPVL
304 IRRL = 13.549% 10,820.12 14,467.66 NPVL = 0
305 IRR S
= 14.489% 10,323.59 14,096.23 NPVS = 0
306 20% $7,685.19 $12,083.33
307
308 $5,000NPV
309
L
310
311 Crossover: Conflict if WACC is to
312 left of crossover, no conflict if
$4,000
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:
NPVL > NPVS
319
320
$2,000
321
322
323
324
$1,000
325
326 IRRS > IRRL
327 NPVS at WACC
328
$0
329
0% 10% 20% Cost of Capital 30%
330
331
332 IRRL
333 -$1,000
334
335
336
337 -$2,000
338
339
340
341
342 PROFITABILITY INDEX (PI) (Section 10.8)
343
344 The profitability index is the present value of all future cash flows divided by the intial cost. It measures the PV per d
of investment.
 A B C D E F
345 of investment.
346
347
348
349 Figure 10-8. Profitability Index (PI)
350
351 Project S: PIS = PV of future cash flows ÷ Initial cost
352 PIS = $31,108.95 ÷ $15,000
353 PIS = 2.0739
354
355 Project L: PIL = PV of future cash flows ÷ Initial cost
356 PIL = $33,300.94 ÷ $15,000
357 PIL = 2.2201
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 fir
370 formal method used to evaluate capital budgeting projects. First, we identify the year in which the cumulative cash i
exceed the initial cash outflows. That is the payback year. Then we take the previous year and add to it the unrecove
371
balance at the end of that year divided by the following year's cash flow. Generally speaking, the shorter the payback
372 period, the better the investment.
373
374
375
376 It's easy to calculate the payback manually--calculate cumulative cash flows and look to see when the cumulative C
377 positive, and recognize that the payback year is the prior year plus a fraction equal to the shortfall divided by the CF
next year. However, it would be useful to have an automated procedure if you were calculating many paybacks or if y
378
wanted to do sensitivity analysis for a given project, but this is more complicated. You can see the formula below, and
379 procedure is explained in detail in our Excel Tutorial. We use the formula only if we must do a number of payback
380 calculations--for just one or two, the manual approach is much easier.
381
382
383
 A B C D E F
384 Figure 10-9. Payback Period
385
386 Years = 0 1 2 3
387 Project S Cash flow -15,000 5,000 10,000 20,000
388 Cumulative cash flow -15,000 -10,000 0 20,000
389 Intermediate calculation for payback - - - 2.00
390
391 Intermediate calculation:
392 Manual calculation of Payback S = 2 + $1,000/$3,000 = 2.00 =IF(F388>0,E386+ABS(E388/F387),"-")
393 Excel calculation of Payback S = #DIV/0! 2.00
394
395 Years 0 1 2 3
396 Project L Cash flow -15,000 20,000 10,000 6,000
397 Cumulative cash flow -15,000 5,000 15,000 21,000
398
399 Manual calculation of Payback L = 3 + $2,000/$6,750 = #DIV/0! Payback is between
400 Alternative Excel calculation of Payback L = negative and positive
cumulative cash flow.
401 =PERCENTRANK(C397:G397,0,6)*G395 = 0.75
402
403
404
405
406
The regular payback has two major flaws. First, it does not take account of any cash flows that occur past the payba
year, no matter how large those flows might be. Second, the payback does not take account of the time value of mone
407
This second problem is addressed with the discounted payback as discussed below, but the failure to consider beyond
408
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
416 Project S Cash flow -15,000.00 5,000.00 10,000.00 20,000.00
417 Discounted cash flow -15,000.00 4,545.45 8,264.46 15,026.30
418 Cumulative discounted CF -15,000.00 -10,454.55 -2,190.08 12,836.21
419
420 Discounted Payback S = 2 + $2,148.76/$2,253.94 = 2.15 Payback is between
421 Excel calculation of Discounted Payback S = negative and positive
422 =PERCENTRANK(C418:G418,0,6)*G415 = 2.15 cumulative discounted cash
423 flow.
424 Years 0 1 2 3
425 Project L Cash flow -15,000.00 20,000.00 10,000.00 6,000.00
426 Discounted cash flow -15,000.00 18,181.82 8,264.46 4,507.89
427 Cumulative discounted CF -15,000.00 3,181.82 11,446.28 15,954.17
428
429 Discounted Payback L = 3 + $3,606.31/$4,610.34 = #DIV/0! Payback is between negative
and positive cumulative
discounted cash flow.
 A B C D E Payback F
is between negative
430 Excel calculation of Discounted Payback L = and positive cumulative
431 =PERCENTRANK(C427:G427,0,6)*G424 = 0.83 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 wealth
438 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
 G H
12
First, we13
analyze Projects S and
heet analyses
14
can be set up
oblems, with just a few years, we
15
problem up as a series of income
16
t.
17
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47
hen sum 48
those discounted cash
alth. 49
50
51
52
53
54
 G H
55
56
57
58
59
60
61
62
63
64
=NPV(B51,C62:F62)+B62
65
66
67
uld accepted.
68
The rationale for
e manager in all respects. If
69
would want to accept the project
70
f considering the above two
71
only accept Project L if they are
72

73
74
75
76
77
t value of78a project's cash inflows
t forces NPV
79 to zero. The
ely requires
80 you to access the
wn below,81along with the data
82
83
84
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87
88
89
90
91
92
93
94
 G H
95
96
97
98
99
100
101
102
103
104
105
d if their IRR
106 is greater than the
utually exclusive
107 projects should
RR that exceeds
108
the cost of
wever, the projects are mutually
109from our conclusion
his differs
RR methods for ranking Projects
110

111
112
113
114
 G H
115
s that have more than one change
e IRR with116 such a project using a
Soln", the 117
HP-17B says
118
ure for correcting the problem is
119
closest to your guess. You can
. However, 120the nature of the
everal hundred
121 percent).
122
123
124
125
126
127
128
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131
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133
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135
136
137
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140
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143
144
145
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148
149
150
151
152
153
154 are plotted to form the
. These data
of the IRR155
is the rate at which the
156
157
158
 G H
159
160
161
162
163
164
165
166
167
168
169
170
171
realistic to172
asssume that cash flows
terion than IRR.
173
174
175
176
177
cash outflows)
178 to equal the present
ture values of the project's cash
179
the outflows and the FV of the
Excel's MIRR180 function.
181
182
183
ash flows184received are reinvested at
the MIRR is a better indicator of a
185
ws can have but one MIRR.
186
187
188rates. Generally,
at different
MIRR where 189 reinvestment is likely
190
191
192
sh flows are
193reinvested at the cost of
competitive world, that the actual
194
high. The MIRR setup can be used
195
196
197
198 of capital and added to
ed at the cost
d in a given199year, the negative flows
he net cash
200flow. This can make a
201
 G H
202
203
204
205
206
207
208
209
210
211
212
213
214
215 28.39%
216 28.39%
217 28.39%
218
219
220
221
222 31.84%
223
224
225
226
227
228
of capital.229
If
R. 230
231
232
233
234
235
236
NPV increases.
237 Figure 10-4, for the
ign only once--a negative for the
238
k like the one in Figure 10-6.
239
240
241
242
243
244
245
 G H
246
247
248
249
250
251
252
253
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271
272
273
274
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276
277
278
279
280
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282
283
284
ect L. The285easiest way to find the
f this differential cash flow stream.
286
287
288
289
290
291
292
293
 G H
297
298
299
300
301
302
303
304
305
306
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326
327
328
329
Capital 30%
330
331
332
333
334
335
336
337
338
339
340
341
342
343
cost. It measures
344 the PV per dollar
 G H
345
346
347
348
349
350
351
352
353
354
355
356
357
358
r than 1.0.359
her PI. 360
361
362
363
364
365
366
367
368
investment,
369 and it was the first
n which the
370 cumulative cash inflows
ear and add to it the unrecovered
aking, the371
shorter the payback
372
373
374
375
to see when
376the cumulative CF turns
he shortfall
377divided by the CF in the
ulating many paybacks or if you
378
an see the formula below, and the
379
ust do a number of payback
380
381
382
383
 G H
384
385
386 4
387 0
388 20,000
389 #DIV/0!
390
391
mediate calculation:
392
E386+ABS(E388/F387),"-")
393
394
395 4
396 0
397 21,000
398
Payback399is between
negative400and positive
cumulative cash flow.
401
402
403
404
405
ows that occur
406
past the payback
unt of the time value of money.
407
he failure to consider beyond-
408
409
410
411
412
413
414
415 4
416 0.00
417 0.00
418 ###
419
420
k is between
421
and positive
discounted422
cash
flow. 423
424 4
425 0.00
426 0.00
427 ###
428
429
ayback is between negative
and positive cumulative
discounted cash flow.
 G
ayback is between negative H
430cumulative
and positive
discounted
431cash flow.
432
433
434
435
436
ct adds to437
shareholder wealth.
438
439
440
441
442
443
444