NPV and IRR Computations

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Note: All IRR and NPV solutions in this lesson are computed using a financial calculator.
Due to rounding errors, solutions may be slightly different if present value tables are used.

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1. The Time Value of Money
1. You likely understand already that time and interest rates are strongly connected.
To state it concisely, interest rates are what make money equal across time. Put
another way, using an interest rate can make one amount of money equal to a
different amount of money at a different point in time. The key to establishing
equality between two different amounts of money is identifying the right interest
rate.
2. You personally experience the equalizing power of interest rates all the time. With
the right interest rate, you are ambivalent between two different amounts of
money at two different points in time. You can think of making a loan to
experience the characteristics of an interest rate. When making a loan to another
person, you are (or should be) concerned about three issues.
1. Since you likely prefer to have your money available right now to spend, you
expect some type of compensation for delaying the use of your own money.
2. You're probably concerned about the risk that you may not get your money
back at the end of the loan, and you want to be rewarded for taking on that
risk. Further, as the risk gets higher, you need more reward.
3. Inflation in the economy causes prices to rise, which means that when you
get your money back at the end of the loan, you can't purchase the same
goods and services. Hence, you'll need the payback amount adjusted in
order to maintain the same ability to consume goods and services.
3. These three factors, desire to consume now, risk of loss, and inflation effects,
combine to form the interest rate you demand on the loan you make to another
person. Similarly, you are (or should be!) considering these same factors on an
investment you make in a business. When the three factors (desire, risk, inflation)
are efficiently combined, you should be largely ambivalent between the money
you loan today and the money paid back to you in the future.
4. The concept of time value of money teaches us that, with the correct interest rate,
the money you loan today and the money paid back in the future is really the
same money. We call these two different amounts of money (present value and
future value) the nominal amounts. When adjusted for the correct interest rate,
these two amounts are the same amount, and are the “real” value in terms of time
value of money.
5. In capital budgeting, the interest rate concept is described using a variety of
different terms, including discount rate, hurdle rate, required rate of return, and
the weighted average cost of capital (WACC).

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2. Working with Your Calculator
1. The time value of money is central to capital budgeting using analysis techniques
such as NPV (net present value) and IRR (internal rate of return). Both of these
techniques base the analysis on discounting future nominal cash flows to present
value terms using the interest rate (i.e., discount rate) that correctly captures
expectations regarding desire, risk, and inflation. This approach is known as
discounted cash flow analysis.
2. Using a financial calculator, computer spreadsheet, or present value factor tables,
you can do discounted cash flow analysis involved in NPV and IRR computations.
In this lesson, we will do discounted cash flow computations using a financial
calculator. Currently, the most common financial calculators in the accounting
and finance profession are various editions of the Hewlett-Packard™ 10Bii+ and
the Texas Instruments™ BA II Plus. The calculator instructions provided in this
lesson will relate to these two types of calculators. It's important that you have
access to specific guidelines for your calculator, available on the Internet or in the
instructions that accompany your calculator.
3. Before beginning discount cash flow computations, it's critical that your
calculator has the proper settings for this lesson. There are two settings you need
to verify, and adjust if needed, on your calculator.
1. Be sure that your calculator is set to end-of-period payments (rather than
beginning-of-period payments). End-of-period payments is typically the
default setting of financial calculators. In these lessons, we assume ordinary
annuity payment streams (versus annuity-due payment streams). Most
calculators will constantly display a “BEG” on the screen if set to beginning-
of-period payments.
2. Be sure that your calculator is set to 1 period per year (rather than 12
periods per year). The default setting for most calculators is 12 periods per
year, so this is an important setting to verify and adjust if needed. In these
lessons, we treat operating cash flows as taking place annually (which is a
significant assumption). Any number of periods per year can be used in
discounted cash flow analyses (quarterly, monthly, weekly, etc.), but be sure
to adjust the discount rate to match the time period of the payment.
1. On Hewlett-Packard™ calculators, you can see the periods-per-year
setting by pressing [Gold shift] key, then [C ALL] key.
2. On Texas Instruments™ calculators, press [2nd], then [P/Y]. If the
display presents 12 or any other number than 1, you'll need to access
instructions for your calculator to change the periods per year to 1.
4. Finally, it is highly recommended before beginning a discount cash flow analysis
on your calculator that you clear the memory of all work from previous time value
of money computations.
1. On Hewlett-Packard™ calculators, press [Gold shift] key, then [C ALL] key.
2. On Texas Instruments™ calculators, press [2nd] key, then [CLR TVM] key.

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3. Net Present Value (NPV)
1. Remember when computing cash flows that there are three categories of cash
flows: Initial cash investment, Operating cash flows, and Cash from final disposal.
These cash flows happen at different points in time. Remember that we can't
directly compare nominal amounts of money today with nominal amounts of
money in the future. We must adjust these cash flows by an appropriate interest
(i.e., discount) rate to put all the money amounts in “real” terms.
2. The NPV method is a straightforward approach to discounting future nominal
cash flows back to the present period in order to be able to directly compare
future flows to present costs. The figure below uses a timeline to demonstrate the
nature of how discounted cash flows work in the NPV analysis method. This
analysis assumes the following cash flows.

Net cash investment: $92,200

Net operating cash flows: $22,900 for five years

Net cash from disposal: $17,000 at end of five years

3. The discounted cash flow analysis figure above demonstrates an example of flows
for a capital investment that takes place across a five-year time period. And it
demonstrates discounting all of the future cash flows back to “Year 0,” which is
the current time period when the initial cash investment was made. The cash flow
discounting takes place using an effective discount rate to bring back each
nominal cash flow across its particular number of time periods to be comparable
with the initial net cash investment. For example, the operating cash flow
$22,900 in Year 2 was discounted back two time periods to Year 0, and both the
operating cash flow of $22,900 and cash from disposal of $17,000 in Year 5 are
discounted back five time periods to Year 0. We will assume in this NPV
computation example that the effective discount rate for this analysis is 8%
annual.

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4. To compute the NPV, we must first discount all future cash flows to the present
value. And then we compare the present value of these future cash flows to the net
cash investment. If the present value of future cash in flows is less than the initial
net cash investment outflow, then the capital investment NPV is less than zero
(negative).
1. On Hewlett-Packard™ calculators, complete the following key strokes:

[Gold shift], [C ALL] → to clear all memory

5, [N] → to enter 5 years as the time period of the investment

8, [I/YR] → to enter 8% as the annual discount rate

22900, [PMT] → to enter $22,900 as the annual operating cash flow

17000, [FV] → to enter $17,000 as the cash from disposal

[PV] → simply pressing this key will compute the combined present value of
all future cash flows

Display: –103,003

2. On Texas Instruments™ calculators, complete the following key strokes:

[2nd], [CLR TVM] → to clear memory of all time value of money

computations

5, [N] → to enter 5 years as the time period of the investment

8, [I/Y] → to enter 8% as the annual discount rate

22900, [PMT] → to enter $22,900 as the annual operating cash flow

17000, [FV] → to enter $17,000 as the cash from disposal

[CPT], [PV] → to compute the combined present value of all future cash
flows

Display: –103,003

5. The present value –$103,003 is negative because the calculator is indicating that
a $103,003 current investment (outflow) is equal to all the future inflows
(positive payments) that you entered in the computation, assuming an 8%
discount rate.

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6. Finally, computing the NPV (net present value) is done by comparing the present
value of future cash flows $103,003 to the net cash investment $92,200. The
difference is $10,803 (= 103,003 – 92,200).
1. It's important to note that this is a positive NPV because the present value
of the future inflows is more than the current net cash investment.
2. Also note that this positive NPV indicates that the internal rate of return
(IRR) for this capital investment is more than the discount rate used to
compute this discounted cash flow analysis.

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4. Internal Rate of Return (IRR)
1. As noted above, a positive NPV indicates that the IRR is higher than the discount
rate used to compute the NPV. On the other hand, a negative NPV would indicate
the IRR is less than the discount rate used. This begs the question: What is the
actual internal rate of return for the capital investment?
2. Keep your attention on the figure above that illustrates the timing and the
discounting of future cash flows for our example. The calculator keystrokes to
compute IRR are not much different from computing NPV. In order to compute
IRR, the calculator will determine a discount rate that sets the combined value of
all future cash flows exactly equal to the net cash investment.
1. On Hewlett-Packard™ calculators, complete the following key strokes:

[Gold shift], [C ALL] → to clear all memory

5, [N] → to enter 5 years as the time period of the investment

–92200, [PV] → to enter the negative $92,200 net cash investment as an

outflow

22900, [PMT] → to enter $22,900 as the annual operating cash flow

(inflows)

17000, [FV] → to enter $17,000 as the cash from disposal (an inflow)

[I/YR] → simply pressing this key will compute the IRR for this capital
investment

Display: 12.00

2. On Texas Instruments™ calculators, complete the following key strokes:

[2nd], [CLR TVM] → to clear memory of all time value of money

computations

5, [N] → to enter 5 years as the time period of the investment

–92200, [PV] → to enter the negative $92,200 net cash investment as an

outflow

22900, [PMT] → to enter $22,900 as the annual operating cash flow

17000, [FV] → to enter $17,000 as the cash from disposal

[CPT], [I/Y] → to compute the IRR for this capital investment

Display: 12.00

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 3. The IRR for this example is 12.00% (more precisely, 11.998%). Be sure to
remember the relationship between NPV and IRR. For this capital investment
example, computing NPV with any discount rate less than 12.00% would result in
a positive NPV. And computing NPV with a discount rate set higher than 12.00%
would result in a negative NPV.
5. Going Forward
1. The example we've explored in this lesson assumes a constant operating cash
flow; that is, all operating cash flows are the same amount each year. That's not
typical of capital investments for most organizations. In the next lesson, we'll
learn how to compute NPV and IRR with uneven operating cash flows.
2. Also bear in mind that capital investment decisions are not based solely on the
financial performance of the capital investment. There are often a number of
investment choices available, and some investment choices may have lower
financial performance but have non-financial values (safety, brand, environment,
etc.) that are important to the organization. NPV and IRR performance, while
important, is certainly not the sole basis for making capital investment decisions.

The Circle-M Company is planning to make an investment into a new piece of equipment to
replace an old piece of equipment. Circle-M's expected rate of return is 10% and the new
equipment has a 10-year life. Below are the expected cash flows associated with this capital
investment.
Net cash investment: $198,000
Net operating cash flows: $32,000 for ten years
Net cash from disposal: $33,000 at end of ten years

What is the NPV and IRR for this investment? Use a business calculator to compute these
values.

Answer

NPV (Net Present Value):

On a Hewlett-Packard™ calculator (for example), complete the following key strokes:
Gold shift], [C ALL] → to clear all memory
10, [N] → to enter 10 years as the time period of the investment
10, [I/YR] → to enter 10% as the annual discount rate
32000, [PMT] → to enter $32,000 as the annual operating cash flow
33000, [FV] → to enter $33,000 as the cash from disposal
[PV] → simply pressing this key will compute the combined present value of all future
cash flows
Display: –209,349 → $209,349 present value of future cash flows
$209,349 – $198,000 = $11,349 NPV

IRR (Internal Rate of Return):

On a Hewlett-Packard™ calculator (for example), complete the following key strokes:

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 [Gold shift], [C ALL] → to clear all memory
10, [N] → to enter 10 years as the time period of the investment
–198000, [PV] → to enter the negative $198,000 net cash investment as an outflow
32000, [PMT] → to enter $32,000 as the annual operating cash flow (inflows)
33000, [FV] → to enter $33,000 as the cash from disposal (an inflow)
[I/YR] → press this key to compute the IRR for this capital investment
Display: 11.23 → 11.23% IRR

Interest rates are based on three characteristics that are specific to organizations and
investments: (1) the desire to have money available now rather than in the future, (2) the
inherent risk that the investment will not pay back the initial amount, and (3) the expectation
of rising prices over time (inflation). Interest rates and discount rates are effectively the same
thing for purposes of computing NPV (net present value) and IRR (internal rate of return).
Using discounted cash flow analysis, NPV determines the present value of all future cash
flows and compares that amount to the initial net cash investment. IRR analysis is similar to
NPV analysis, but instead of using a discount rate to determine and compare the present
value of future flows to the initial investment, this method identifies this discount rate (which
is the IRR) that forces the present value of future cash flows to be equal to the initial
investment. Be sure to practice NPV and IRR computations on your own calculator.

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