FIN3113

Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback

FIN3113-009
Chapter 9
Net Present Value (NPV) and Other
Investment Criteria

Payback Rule
Disc. Payback

NPV

Siqi Wei

IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

Department of Finance
Spears School of Business
Oklahoma State University

Spring 2016

Overview
FIN3113
Chapter 9:
NPV

Siqi Wei

Overview

Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV

4
5

IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

6
7

Overview
Outline
Capital Budgeting
Payback & Discounted Payback Rule
Payback Rule
Dicounted Payback
Net Present Value
Internal Rate of Return
IRR
Nonconventional Cash Flows
Multiple IRRs
Mutually Exclusive Investments and Crossover Rate
Modified IRR
Profitability Index
Excercises

Overview
FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

Long-term investments represent sizable outlays of funds that

commit a firm to some course of action. Consequently, the firm
needs procedures to analyze and select its long-term
investments.
Capital budgeting
Capital budgeting is the process of evaluating and selecting
long-term investments that are consistent with the firms goal
of maximizing owners wealth
Firms typically make a variety of long-term investments,
but the most common is in fixed assets, which include
property (land), plant, and equipment.
fixed asset investments are generally long-lived and not
easily reversed once they are made

Objectives
FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting

What services will we offer or what will we sell?

In what markets will we compete?
What new products will we introduce?
**The answer to any of these questions will require that the
firm commit its scarce and valuable capital to certain types of
assets.

Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

Each possible investment is an option available to the firm.

Some options are valuable and some are not. The essence of
successful financial management, of course, is learning to
identify which are which.
Learning objectives
This chapter presents and compares a number of different procedures
used in practice. The primary goal is to acquaint you with the
advantages and disadvantages of the various approaches

Some key terminologies

FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

A capital expenditure is an outlay of funds by the firm

that is expected to produce benefits over a period of time
greater than 1 year
Independent v.s. Mutually Exclusive Projects
Independent projects are those whose cash flows are
unrelated to (or independent of) one another; the
acceptance of one project does not eliminate the others
from further consideration.
Mutually exclusive projects are those that have the same
function and therefore compete with one another. The
acceptance of one eliminates from further consideration all
other projects that serve a similar function.
if we own one corner lot, then we can build a gas station
or an apartment building, but not both. These are
mutually exclusive alternatives.
accepting any one option eliminates the immediate
need for either of the others

Some key terminologies, Contd.

FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

Accept-Reject versus Ranking Approaches

The accept-reject approach involves evaluating capital
expenditure proposals to determine whether they meet the
firms minimum acceptance criterion.
The ranking approach involves ranking projects on the
basis of some predetermined measure, such as the rate of
return. The project with the highest return is ranked first,
and the project with the lowest return is ranked last.
Only acceptable projects should be ranked. Ranking is
useful in selecting the best of a group of mutually
exclusive projects and in evaluating projects with a view
of capital rationing.

Tools
FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

Investment Criteria
Payback Rule
Discounted Payback

Net Present Value (NPV)

NPV

Internal Rate of Return (IRR)

IRR

Modified IRR (MIRR)

IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

Profitability Index

Payback Rule
FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

Payback period (PP)

The payback period is the amount of time required for the firm to
recover its initial investment in a project, as calculated from cash
inflows.
Loosely, the payback is the length of time it takes to recover the
initial investment
In the case of an annuity, the payback period can be
found by dividing the initial investment by the annual cash
inflow.
For a mixed stream of cash inflows (uneven cash
flows), the yearly cash inflows must be accumulated until
the initial investment is recovered.
If the payback period is less than the maximum acceptable
payback period (cutoff point), accept the project.

Payback Rule: Example

FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting

Payback Period: Example

Suppose the company is thingking about a project with the
below cash flow pattern; If the company requires a payback of
3 years (cuttoff point), is the project acceptable?

Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

at T0 , the initial investment is $50,000.

at T1 , the firm has recovered $30,000, leaving $20,000.
at T2 , The CF in the second year is exactly $20,000, so
this investment pays for itself in exactly 2 years.
2 < 3, accept

Payback Rule: Example

FIN3113
Chapter 9:
NPV
Siqi Wei

*When the numbers dont work out exactly, it is customary to

work with fractional years.
Now consider a project with following cash flow pattern:

Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

T1 : $165,000-63,120 = 101,880, need to get to 0 so keep going

NPV

T2 : $101,880-70,800 = 31,080, need to get to 0 so keep going

IRR

T3 : $31,080-91,080 =-60,000, passed 0 so payback is

achieved
31, 080
PP = 2 +
= 2.34 years, It takes 2.34 years to
91, 080
recover the initial cost

IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

If the maximum acceptable payback period (cutoff point)

is more than 2.34 years, the project would be accepted.

Is Payback Period a good criteria?

FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

We need to ask ourselves the following questions when

evaluating capital budgeting decision rules:
Does the decision
Does the decision
Does the decision
are creating value

rule adjust for the time value of money?

rule adjust for risk?
rule provide information on whether we
for the firm?

Drawback of Payback Period measure

FIN3113
Chapter 9:
NPV

Drawbacks?

Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

The major weakness of the payback period is that the

appropriate payback period is merely a subjectively
determined number
We dont really have an objective basis for choosing a
particular number.

There is no discounting involved, so the time value of

money is completely ignored
cash flows after the cutoff point are also ignored entirely
Biased against long-term projects (A, E)

Dicounted Payback-an augmented version

FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback

Discounted Payback
How long does it take to get the initial cost back after you
bring all of the cash flows to the present value.

Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

Estimate the present value of the cash flows

Subtract the future cash flows from the initial cost until
the initial investment has been recovered

Dicounted Payback, Contd.

FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

Year 1: 165,000-56,357 = 108,643; continue

Year 2: 108,643-56,441 = 52,202; continue
Year 3: 52,202-64,829 = -12,627; finished
52202
Discounted Payback = 2 +
= 2.81 years
64829
*If the managements criteria number is 3, then we would
ACCEPT this project as the discounted payback period is less
than the managements number of 3 years.

Dicounted Payback-interpretation
FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

The ordinary payback (PP) is the time it takes to break

even in an accounting sense.
For Dicounted Payback, because it includes TVM, the
discounted payback is the time it takes to break even in an
economic or financial sense.
Loosely speaking, in the above example, we get our money
back, along with the interest we could have earned
elsewhere, in 2.81 years.

Although Discounted Payback take time value of the

money into account, But it still ignores the cash
flows after the cutoff point

Net Present Value (NPV)

FIN3113
Chapter 9:
NPV
Siqi Wei

A firm should undertake an investment only if the PV of the

cash flow that the investment generates is greater than the
cost of making the investment in the first place.

Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV

NPV
The difference between the market value of a project (or
investment) and its cost.
NPV=PV of future cash inflows initial outlays

IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises


CF1
CF2
CFn
+
+ ... +
NPV =
CF0
(1 + r )1
(1 + r )2
(1 + r )n
n
X
CFt
CF0
=
(1 + r)t
t=1

NPV
FIN3113
Chapter 9:
NPV
Siqi Wei
Overview

Steps
Estimate the future cash flows
Estimate the required return for projects of this risk level.

Outline

Capital
Budgeting

Find the present value of the cash flows and subtract the
initial investment.

Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

Accept the project if NPV > 0, otherwise reject

A positive NPV means that the project is expected to
add value to the firm and will therefore increase the
wealth of the owners (investors).
Since our goal is to increase owner wealth, NPV is a
direct measure of how well this project will meet our
goal, as measured in dollar terms.

Estimate NPV
FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

NPV=PV of future CFCF0 =177,627-165,000= $12,627> 0

*If the NPV is positive (NPV > $0), then we ACCEPT the
project. Conversely, if the NPV is negative, then we REJECT
the project.

Estimate NPV
FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

NPV Example
Imagine we are thinking of starting a business to produce and
sell a new product, an organic fertilizer. suppose we believe the
cash revenues from our fertilizer business will be $20,000 per
year. Cash costs (including taxes) will be $14,000 per year.
We will wind down the business in 8 years. The plant,
property, and equipment will be worth $2,000 as salvage at
that time. The project costs $30,000 to launch. We use a
15% discount rate. Is this a good investment? If there are
1,000 shares of stock outstanding, what will be the effect on
the price per share of taking this investment?

Estimate NPV: an Example, Contd.

FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

Dicount back all the future inflows at 15%.

*In this case, net inflows are all $6,000 (annuity), salvage value at
the end of the last year. Similar with bonds cash flow pattern

PMT=6000, N=8, FV=2000, I/Y=15 PV=$27,578

NPV=-30,000+27,578=-$2422 < 0, reject
taking it would decrease the total value of the stock by $2,422.
With 1,000 shares outstanding, this project will incur a loss of
value of $2,422/1,000 = $2.42 per share.

A Note on the use of your Calculator

FIN3113
Chapter 9:
NPV

When calculating the NPV analysis,

if the cash flows are uneven, then use the [CF] worksheet, input
all your cashflows and adjust the cashflow frequency (if needed),
if there are certain patterns, then just use the formula

Siqi Wei
Overview
Outline

if the cash flows are in the form of annuity, use the annuity
formula, or just input [PMT],[I/Y],[N],[FV] and solve for [PV]1 ,
or use CF and adjust CF frequency

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

if the cash flows are in the form of growing annuity, use the
growing annuity formula

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

Keep in mind
Always identify Cash Flow Patterns first
1

Be careful, this PV is not your NPV, its just the PV of future CFs; To
calculate the NPV, you need to take the difference between the PV of
future CF and CF0

Internal Rate of Return, IRR

FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting

Internal Rate of Return, IRR

The internal rate of return (IRR) is the discount rate that
equates the NPV of an investment opportunity with $0
It is the rate of return that the firm will earn if it invests in
the project and receives the given cash inflows

Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises


CFt
CFt
CFt
$0 =
+
+ ... +
CF0
(1 + IRR)t
(1 + IRR)t
(1 + IRR)t
n
X
CFt
=
CF0
(1 + IRR)t
t=1

CF0 =

n
X
t=1

CFt
(1 + IRR)t

IRR
FIN3113
Chapter 9:
NPV
Siqi Wei

IRR is the most important alternative to NPV

Overview
Outline

Capital
Budgeting
Payback

IRR is often used in practice and is intuitively appealing

IRR is based entirely on the estimated cash flows and is
independent of interest rates found elsewhere

Payback Rule
Disc. Payback

NPV

Accept the project if IRR > required return

IRR

Based on the IRR rule, an investment (project) is acceptable if

the IRR exceeds the required return (opportunity cost). It
should be rejected otherwise.

IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

IRR
FIN3113
Chapter 9:
NPV
Siqi Wei

*An illustration of IRR: If you do not have a financial

calculator, then this becomes a trial and error process

Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

Enter the cash flows as you did with NPV

Press IRR and then CPT
IRR=16.13%>12% required return: thus we ACCEPT
the project
Fiancial Calculator: IRR
Use the [CF] worksheet on your financial calculator to solve
for the IRR

Example: IRR, NPV

FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

IRR
Suppose we have a sequence of cash flows in the form of a
two-period, $60 annuity. At 10% of discount rate, what is
NPV? What is IRR that makes NPV=0?

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV

NPV:

IRR

Given [PMT]=60,[N]=2,[I/Y]=10 [PV], Then [PV]CF0 =$4.13

IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

IRR is the rate that equate the NPV to be 0:

NPV = 0 = 100 +

60
60
+
IRR =?
(1 + IRR)1 (1 + IRR)2

Trial and error or financial calculator 13.1% IRR

Example: IRR, NPV, (NPV Profile)

FIN3113
Chapter 9:
NPV
Siqi Wei
Overview

Now, allowing for different levels of discount rates (0%, 5%, 10%,
15%, 20%), what would happen to the NPVs?

Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

NPVs at different discount rates

Example: IRR, NPV, (NPV Profile)

FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

Plot NPV (y-axis) against discount rates (x-axis)

this grapical representation of the relation between NPV
and various discount rates is called NPV profile

IRR & NPV

FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

Question: Are the IRR and NPV rules always lead to identical
decisions?
The answer is yes, as long as two very important
conditions are met.
First, the projects cash flows must be conventional,
meaning that the first cash flow (the initial investment)
is negative and all the rest are positive.
Second, the project must be independent, meaning that
the decision to accept or reject this project does not affect
the decision to accept or reject any other

Nonconventional Cash Flows

FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting

Nonconventional Cash Flows: cash flow signs change more

than once
Suppose we have a strip-mining project that requires a $60
investment. Our cash flow in the first year will be $155. In the
second year, the mine will be depleted, but we will have to
spend $100 to restore the terrain.

Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

to illustrate the idea, first look at the NPVs at different

levels of discount rates

Nonconventional Cash Flows & Multiple IRRs

FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

Multiple IRRs
More than one IRR
resulting from a
capital budgeting
project with a
nonconventional
cash flow pattern;
the maximum
number of IRRs
for a project is
equal to the
number of sign
changes in its
cash flows.

Mutually Exclusive Investments

FIN3113
Chapter 9:
NPV
Siqi Wei

Mutually Exclusive Investments

A situation in which taking one investment prevents the taking
of the another.

Overview
Outline

Capital
Budgeting

Given two or more mutually exclusive investments, which one is

the best?

Payback
Payback Rule
Disc. Payback

NPV
IRR

*To illustrate the problem with the IRR rule and mutually exclusive
investments, consider the following cash flows from two mutually
exclusive investments:

IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

IRRA = 24% > IRRB = 21%, Can we make decision based on this?

Mutually Exclusive Investments & Conflict Ranking

- use NPV!
FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

IRRA = 24% > IRRB = 21%,

if you compare the
NPVs, youll see
that which
investment has the
higher NPV
depends on our
required return.
If our required return is 10%, then B has the higher NPV and is
thus the better of the two even though A has the higher return.
If our required return is 15 percent, then there is no ranking
conflict: A is better.
When we have mutually exclusive projects, we dont rank them
based on returns. Anytime we are comparing mutually exclusive
projects, looking at IRRs can be misleading. Use NPV.

Mutually Exclusive Investments & Crossover rate

FIN3113
Chapter 9:
NPV
Siqi Wei
Overview

The NPV profile also

illustrates the idea
of conflict ranking

Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

The crossover rate

is the discount rate
that makes the
NPVs of two
projects equal.

How to find crossover rate?

First, take the difference of CFs of the two mutually
exclusive projects t = CFAt CFBt
Second, find the rate (IRRt ) that makes NPVt = 0

Example: Crossover rate & NPV

FIN3113
Chapter 9:
NPV
Siqi Wei

Example: crossover rate & NPV

Consider the following two mutually exclusive projects:
Calculate the IRR for each project.

Overview
Outline

Capital
Budgeting

What is the crossover rate for these two projects?

What is the NPV of Projects X and Y at r =0%, 15%, 25%?

Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

*The IRR is the interest rate that makes the NPV of the project
equal to zero
**To find the crossover rate, we subtract the cash flows from one
project from the cash flows of the other project, and find the IRR of
the differential cash flows.

Example: Crossover rate & NPV, Contd

FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

IRR & Crossover rate of Project X & Project Y

Example: Crossover rate & NPV, Contd

FIN3113
Chapter 9:
NPV

NPV of Project X, allowing for different levels of r

Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

NPV of Project Y, allowing for different levels of r

Modified Internal Rate of Return (MIRR)

FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Modified Internal Rate of Return (MIRR)

Negative cash flows (CF ) are discounted back to the present, and
positive cash flows (CF+ ) are compounded to the end of the project.
Then solve for the IRR.

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV

T0 : $60 +

IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

T1 : 0
T2 : $155 (1 + 20%)1 = $186
then solve for the IRR of these new cash flows
MIRR=19.87% 2

Profitability
Index
Excercises

$100
= $129.44, Discount back CF
(1 + 20%)2

There are many ways of calculating MIRR; in this course, you only
need to know the combination approach, the Method # 3 on your book

Modified Internal Rate of Return (MIRR)

FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting

MIRR Excercise
Calculate the MIRR. The opportunity cost is 7%

Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

Negative cash flows (CF ) are discounted back to the

present, and positive cash flows (CF+ ) are compounded
to the end of the project. Then solve for the IRR.

MIRR excercise
FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

Profitability Index (PI)

FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

Profitability Index (PI)

A variation of the NPV rule is called the profitability index
(PI). For a project that has an initial cash outflow followed by
cash inflows, the profitability index (PI) is simply equal to the
present value of cash inflows divided by the initial cash outflow
PV of future cashflows
CF0
Pn
CFt
t=1
(1 + r )t
=
CF0
NPV
=
+1
CF0

PI =

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

Decision rule
Accept if PI > 1.0

Profitability Index (PI)

FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

Example: PI
If a project costs $200 and the present value of its future cash
flows is $220, the profitability index value would be
$220/200 = 1.1. This tells us that, per dollar invested, $1.10
in value or $.10 in NPV results, that is, the value created
per dollar invested.
PI normaly can be used as a measure of performance for
government or other not-for-profit investments. Also,
when capital is scarce, it may make sense to allocate it to
projects with the highest PIs.
PI is closely related to NPV, generally leading to identical
decisions.
PI may lead to incorrect decisions in comparisons of
mutually exclusive investments.

Excercises: Q1
FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

Q1 (Basic and Important!) Be proficient on this

PING Inc. is evaluating a long-term investment in an additional
production facility to be built adjacent to their existing factory.
They have estimated the following cash flows for the project.
PING has an opportunity cost of capital of 10%. Should
PING proceed and invest in this additional facility? Calculate
the payback period, discounted payback period, NPV,
IRR, PI, and MIRR. The following cash flows are in
thousands.
CF0 = 10, 510, CF1 = 5, 450, CF2 = 4, 250, CF3 = 3, 000,
CF4 = 2, 000, CF5 = 1, 000

Excercises: Q1, Contd.

FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

Excercises: Q1, Contd.

FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

Excercises: Q1, Contd.

FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

Excercise: Q2
FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

Q2
Below are the cash flow forecasts for two mutually exclusive
projects
Which project would you choose if the opportunity cost is
2%?
Which project would you choose if the opportunity cost is
12%?
Why does your answer change?
What is the crossover rate?

Excercises: Q2, Contd

FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

Excercise: Q3
FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

Q3
Batesville Casket Company is evaluating the opening of a new
casket and vault production operation. The project will provide
a net cash inflow of $90,000 next year. Demand is very steady,
therefore cash flows are projected to grow at a rate of 4% each
year forever. The project requires an initial cash outflow of
$1,500,000. The firm has an opportunity cost of 11%. Should
BCC begin construction of the new factory? The firm has
experienced difficulty estimating the growth rate, therefore
what is the break-even growth rate that would provide a NPV
of -0-?

Excercises: Q3, Contd

FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

Excercises: Q4
FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV

Q4
XYZ Company is evaluating the following project. Calculate
the MIRR using the Combination Approach (Discount negative
cash flows using the discount rate and compound positive cash
flows at the reinvestment rate, then calculate the I/Y with the
new initial cash outflow and future cash inflow). The
opportunity cost is 7%.

IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises

*in this question reinvestment rate and discount rate all 7%

Excercises: Q4, Contd

FIN3113
Chapter 9:
NPV
Siqi Wei
Overview
Outline

Capital
Budgeting
Payback
Payback Rule
Disc. Payback

NPV
IRR
IRR
Nonconventional
CF
Multiple IRRs
Mutually
Exclusive
MIRR

Profitability
Index
Excercises