Example 1
Imagine a project costs $ 1,000 today and produces $ 600 in each of the next two years. If the
discount rate is 10 % , then:
PV of Year 1=$ 600 /1.10=$ 545.45
PV of Year 2=$ 600 /¿
Total PV = $1,041.32
NPV =$ 1,041.32−$ 1,000=$ 41.32
Since NPV ¿ 0, the project adds value. If we had to choose among projects, we would select the
one with the largest positive NPV.
Example 2
Suppose a project requires an investment of $2,000. It generates the
following annual cash inflows:
Year 1: $800
Year 2: $600
Year 3: $700
By the end of Year 1, $800 has been recovered.
By the end of Year 2, a total of $1,400 has been recovered.
By the end of Year 3, the total is $2,100, which exceeds the initial $2,000.
So the project’s payback period is just under 3 years.
If management’s rule is “3 years or less,” then this project would be
accepted.
Example 3
Suppose we invest $ 1,000 today and get back $ 1,210 in one year.
Here the IRR is the rate r that solves:
1,210
0=−1,000+
1+ r
That gives r =21 %.
So the IRR of this project is 21 %.
If the firm's required return is only 10 % , this project easily qualifies because
21 %> 10 %.
Example 4
Comparing Investment Criteria Consider the following cash flows of two
mutually exclusive projects for Tokyo Rubber Company. Assume the
discount rate for both projects is 8 percent.
Yea Dry Solvent
r Prepreg Prepreg
0 −$ 1,800,000 −$ 715,000
1 1,080,000 380,000
2 840,000 627,000
3 870,000 396,000
a. Based on the payback period, which project should be taken?
b. Based on the NPV, which project should be taken?
c. Based on the IRR, which project should be taken?
d. Based on this analysis, is incremental IRR analysis necessary? If yes,
please conduct the analysis.
(a) Payback period
Cumulative (undiscounted) cash flow until it turns non-negative; if it
happens within a year, use a fraction.
Dry Prepreg
End of Year 0: −1,800,000
End of Year 1: −1,800,000+1,080,000=−720,000
End of Year 2: −720,000+840,000=+120,000 → payback occurs during
Year 2.
Fraction of Year 2 needed ¿ 720,000/840,000=0.8571.
Payback ¿ 1+0.8571=1.86 years.
Solvent Prepreg
End of Year 0: −715,000
End of Year 1: −715,000+380,000=−335,000
End of Year 2: −335,000+627,000=+292,000 → payback during Year 2.
Fraction of Year 2 needed ¿ 335,000/627,000=0.5343.
Payback ¿ 1+0.5343=1.53 years.
Choice by payback: Solvent Prepreg (shorter payback).
(b) Net Present Value (NPV)
3
C Ft
NPV =∑ ❑
t=0
¿¿
Dry Prepreg
Year 0: −1,800,000
Year 1: 1,080,000/1.08=1,000,000
Year 2: 840,000 /1.08 2=720,164.61
Year 3: 870,000 /1.08 3=690,634.05
NPV =−1,800,000+1,000,000+720,164.61+690,634.05=+610,798.66
Solvent Prepreg
Year 0: −715,000
Year 1: 380,000/1.08=351,851.85
Year 2: 627,000 /1.08 2=537,551.44
Year 3: 396,000/1.083 =314,357.57
NPV =−715,000+351,851.85+537,551.44 +314,357.57=+488,760.86
Choice by NPV: Dry Prepreg (higher NPV).
(c) Internal Rate of Return (IRR)
C Ft
IRR solves ∑3 .
t=0 ¿¿
Dry Prepreg IRR ≈ 26.84 %
Solvent Prepreg IRR ≈ 42.20 %
Choice by IRR: Solvent Prepreg (higher IRR).
Note: The IRR and NPV rankings conflict because the projects have different
scales (initial outlays differ). For mutually exclusive projects, resolve with
incremental analysis.
Example 5 MIRR
Suppose a project costs $ 1,000 today (Year 0 ) and generates $ 500 in Year 1
and $ 700 in Year 2.
We discount the outflow at the borrowing rate (say 8 % ). PV(outflows)
¿ $ 1,000.
We compound the inflows at the reinvestment rate (say 10 % ):
FV inflows ¿ $ 500 ×1.10+ $ 700=$ 1,250 .
Now we solve for the MIRR that equates $ 1,000 today with $ 1,250 in
two years:
¿
So the MIRR is about 11.8% , which is higher than the cost of capital and thus
acceptable.
MIRR
A project has the following cash flows (in dollars):
Year 0: -5,000 (initial investment)
Year 1: +1,500
Year 2: +2,000
Year 3: +2,500
Year 4 :+3,000
Assume the finance (borrowing) rate ¿ 8 % and the reinvestment rate ¿ 10 % .
Calculate the Modified Internal Rate of Return (MIRR).
Step 1: Compound positive cash inflows to the end (Year 4) using the reinvestment rate ( 10 % )
F V inflows ¿
Step 2: Discount negative cash flows to Year 0 using the borrowing rate ( 8 % )
Here we only have the initial outflow at Year 0:
P V outflows =5000
(Since it is already at Year 0, the borrowing rate has no numerical effect.)
Step 3: Solve for MIRR
The MIRR is the rate that equates the PV of outflows with the FV of inflows:
¿
Interpretation
This means that, given financing at 8% and reinvestment at 10%, the project earns an equivalent
return of about 19.4% per year. If the company’s required rate of return is below 19.4%, the
project should be accepted.
Example 6
Imagine two projects:
Project A: Invest $ 1,000 now, get $ 1,500 in one year. IRR ¿ 50 % , NPV =¿
about $ 364 at 10 % .
Project B: Invest $ 10,000 now, get $ 13,000 in one year. IRR
¿ 30 % , NPV =¿ about $ 818 at 10 % .
IRR says Project A is better ( 50 % >30 % ).
But NPV says Project B creates more value ( $ 818> $ 364 ).
Which should the firm choose? → Project B, because maximizing NPV means
maximizing shareholder wealth.
Example 7
Suppose Project A requires a $ 1,000 investment and generates $ 1,300 in
present value of future cash flows.
1300
PI = =1.3
1000
That means for every $ 1 invested, we get $ 1.30 in value. Since PI > 1, we
accept the project.