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NPV IRR

The document explains how to calculate the present value of uneven cash flows using the NPV function in Excel, which does not include the initial cash outflow. It also discusses the calculation of Net Present Value (NPV), Internal Rate of Return (IRR), and Modified Internal Rate of Return (MIRR), highlighting their definitions and how to use them in Excel. The investment example provided shows that with a cost of $800, the NPV is $200.18, the IRR is 19.54%, and the MIRR is 17.12%, indicating a favorable investment decision.

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4 views

NPV IRR

The document explains how to calculate the present value of uneven cash flows using the NPV function in Excel, which does not include the initial cash outflow. It also discusses the calculation of Net Present Value (NPV), Internal Rate of Return (IRR), and Modified Internal Rate of Return (MIRR), highlighting their definitions and how to use them in Excel. The investment example provided shows that with a cost of $800, the NPV is $200.18, the IRR is 19.54%, and the MIRR is 17.12%, indicating a favorable investment decision.

Uploaded by

anshakd26
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Present Value of Uneven Cash Flows

To find the present value of an uneven stream of cash flows, we need to use the NPV (net present
value) function. This function is defined as:

NPV(Rate,Cash Flow 1,Cash Flow 2,Cash Flow 3, ...)

Note that we don't generally list each cash flow separately. Typically, the cash flows will be in a
contiguous range on the worksheet and we simply give the address of the range for Cash Flow 1.

Suppose that you are offered an investment that will pay the following cash flows at the end of
each of the next five years:

Period Cash Flow


0 0
1 100
2 200
3 300
4 400
5 500

How much would you be willing to pay for this investment if your required rate of return is 12%
per year?

We could solve this problem by finding the present value of each of these cash flows
individually and then summing the results. However, that is the hard way. Instead, we'll use the
NPV function. Set up a worksheet as shown below:
Now, select B11 and type: =NPV(B1,B5:B9) and you will see that the answer is $1,000.18.
Make a special note of the fact that we did not include the period 0 cash flow in the function. The
NPV function has no way of knowing when a cash flow occurs, so it assumes that the first cash
flow in the range occurs one period in the future.

You can now change any of the numbers in the worksheet and immediately see the result. For
example, if you change B1 to 10% you will find that the answer is now $1,065.26. If you change
B9 to 1,000 then the present value (still at a 10% interest rate) will change to $1,375.72. Reset
the interest rate to 12% and B9 to 500 before continuing.

Net Present Value (NPV)


Calculating the net present value (NPV) and/or internal rate of return (IRR) is virtually identical
to finding the present value of an uneven cash flow stream as we did in previous example.
However, be aware that Excel's NPV function doesn't really calculate net present value. Instead,
it simply calculates the plain old present value of uneven cash flows. It does not, and this is
vitally important, take the cost of the investment into account.

Suppose that you were offered the investment in Example 3 at a cost of $800. What is the NPV?
IRR? MIRR?

Make a copy of your previous worksheet and paste it into a new worksheet, so that it looks like
the one below.

Recall that the NPV, according to the actual definition, is calculated as the present value of the
expected future cash flows less the cost of the investment. As we've seen, we can use the NPV
function to calculate the present value of the uneven cash flows in this example. Then, we need
to subtract the $800 cost of the investment.

Therefore, the formula to calculate the net present value is: =NPV(B1,B5:B9)+B4 and the
answer is $200.18. Note that since the cost of the investment is given as a negative number in B4
(it is a cash outflow), We have to ADD it to the result of the NPV function. In other words, the
PV of the cash flows is $1,000.18 as we calculated in the previous example, and subtracting
$800 leaves us with $200.18 (the net present value)

Internal Rate of Return


Solving for the IRR is easier, because the IRR function does take the initial outlay into account
automatically. This IRR function is defined as:

IRR(values,guess)

Note that the "values" is a contiguous range of cash flows, including the initial outlay. The
"guess" argument is optional and generally isn't needed. For this problem, the function in B12 is:
=IRR(B4:B9).

As seen above, the answer is 19.54%. This means that if you purchase the investment for $800
today, your compound average annual rate of return will be 19.54% per year.

Modified Internal Rate of Return


The IRR calculation implicitly assumes that you will reinvest the cash flows at the same rate as
the IRR. Often, this assumption is unrealistic and can lead to expectations about the rate of return
that are too high. That is why it is better to calculate the Modified Internal Rate of Return
(MIRR), which allows you to specify an alternative reinvestment rate.

The MIRR function is defined almost identically to the IRR function, except that it has a
reinvestment rate argument (and there is never a need for a "guess"):

MIRR(values,finance_rate,reinvest_rate)
In this function "values" is a contiguous range of cash flows (including the initial outlay),
finance_rate is your required rate of return (i.e., the discount rate), and reinvest_rate is the
reinvestment rate.

Excel will use the finance_rate to calculate the present value of all of the cash outflows, and the
reinvest_rate to calculate the future value of all of the cash inflows. The MIRR is the interest rate
that makes the present value of the outflows grow to the future value of the inflows over the life
of the investment.

Theoretically, the reinvestment rate should usually be the same as the cost of capital, so we
usually set both the finance_rate and reinvest_rate to the same interest rate. To calculate the
MIRR in B13, use the formula: =MIRR(B4:B9,B1,B1).

As you can see, the MIRR is 17.12%. This means that if you pay $800 for the investment and
reinvest the cash flows at a rate of 12% per year, you compound average annual rate of return
will be 17.12% per year.

As a final note, realize that this investment should be accepted because its NPV is greater than 0,
its IRR is greater than the 12% cost of capital, and its MIRR is also greater than its cost of
capital.

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