Internal Rate of Return (IRR) and Net Present Value (NPV)

Net present value (NPV): the sum of the present values of all cash inflows minus the sum of the present values of all cash outflows. The internal rate of return (IRR): (1) the discount rate that equates the sum of the present values of all cash inflows to the sum of the present values of all cash outflows; (2) the discount rate that sets the net present value equal to zero. The internal rate of return measures the investment yield.

IRR and NPV

Example: Yield on a single receipt. An investor can purchase a vacant lot for $28,371 and expects to sell it for $50,000 in 5 years. What is the expected IRR for this investment?

1 PV FV (1 d )n
1 $28,371 $50,000 (1 d ) 5
d = 12%

IRR and NPV

HP 10B Keystrokes
CLEAR ALL 1 28371 50000 5 N I/YR P/YR +/FV PV

Clears registers One payment per year PV = -$ 28,371 FV = $ 50,000 FV in 5 years Solve for IRR

IRR and NPV

Example: NPV for a single receipt. An investor can purchase a vacant lot for $28,371 and expects to sell it for $50,000 in 5 years. What is the expected NPV for this investment if the investor discounts future cash flows at 15%?

1 NPV PV FV (1 d )n
1 NPV $28,371 $50,000 (1 0.15) 5
NPV = -$28,371 + $24,858.84 = - $3,512.16

IRR and NPV

HP 10B Keystrokes
CLEAR ALL 1 P/Y R

50,000 FV 15 5 PV I/Y R N

+/28,371

Clears registers One payment per year $50,000 future value Discount rate = 15% FV in 5 years Compute present value Subtract $28,371

IRR and NPV

Example: Yield on an Ordinary Annuity An investor has the opportunity to invest in real estate costing $28,371 today. The investment will provide $445.66 at the end of each month for the next 8 years. What is the (annual) IRR (compounded monthly) for this investment?

1 PV PMT d t t 1 (1 ) k 1 $28,371 445.66 d t t 1 (1 ) 12 d 0.9167%; d 110% . 12

96

nk

IRR and NPV

HP 10B Keystrokes

CL E A R A L L P/ YR

12 2 8 ,3 7 1

+/-

PV

4 4 5 .6 6 P M T 8 I/ Y R x P/ YR

Clears registers Monthly compounding PV = - $28,371 Monthly pmt = $445.66 96 months Compute IRR

IRR and NPV

Example: NPV for an Ordinary Annuity
An investor has the opportunity to invest in real estate costing $28,371 today. The investment will provide $445.66 at the end of each month for the next 8 years. What is the NPV for this investment if the investor discounts future cash flows monthly at a 10% annual rate?

1 NPV $28,371 44566 . 010 t . t 1 (1 ) 12

NPV = - $28,371 + $29,369.66 = $998.66

96

IRR and NPV

HP 10B Keystrokes

CL E A R A L L P/ YR PM T

12 4 4 5 .6 6 10 8 PV

I/ Y R

x P/ YR

+/2 8 ,3 7 1

Clears registers Monthly payments Monthly pmt = $445.66 Annual discount rate = 10% 96 monthly payments Compute PV Subtract $28,371

IRR and NPV

Example: What is the IRR for an investment that costs $96,000 today and pays $1028.61 at the end of the month for the next 60 months and then pays an additional $97,662.97 at the end of the 60th month?

1 FV PV PMT d d nk t 1 (1 ) t (1 ) k k 1 $97,662.97 $96,000 $1,028.61 d t d 60 t 1 (1 ) (1 ) 12 12

60

nk

d/12 = 1.0921% ; d = 13.10%

IRR and NPV

HP 10B Keystrokes
Clears registers Monthly payments PV = -$96,000 Monthly pmt = $1,028.61 FV = $97,662.97 60 months Compute yield (IRR)

CL E A R A L L P/ YR

12 9 6 ,0 0 0

+/-

PV

1 ,0 2 8 .6 1 P M T 9 7 ,6 6 2 .9 7 FV 5 I/ Y R x P/ YR

IRR and NPV

Example: NPV for an ordinary annuity with an addition lump sum receipt at the end of the investment term. What is the NPV for an investment that costs $96,000 today and pays $1028.61 at the end of the month for the next 60 months and then pays an additional $97,662.97 at the end of the 60th month if the investor discounts expected future cash flows monthly at the annual rate of 13.1047%?
1 FV NPV PV PMT d t d t 1 (1 ) (1 )nk k k 60 1 $97,662.97 NPV $96,000 $1,028.61 0131047 t . 0131047 60 . t 1 (1 ) (1 ) 12 12
nk

NPV = - $ 96,000 + $ 96,000 = $ 0

IRR and NPV

HP 10B Keystrokes
Clears registers Monthly payments Monthly pmt = $1,028.61 FV = $97,662.97 60 months of payments Discount rate = 13.1047% Compute PV Subtract $96,000

CL E A R A L L 12 P/ YR

1 ,0 2 8 .6 1 P M T 9 7 ,6 6 2 .9 7 FV 5 x P/ YR I/ Y R

1 3 .1 0 4 7 PV

+/9 6 ,0 0 0

IRR and NPV

Example: IRR for uneven cash flows. What is the IRR for an investment that costs $100,000 today and pays $20,000 one year from today; $35,000 two years from today; and $75,000 three years from today?

$20,000 $35,000 $75,000 $100,000 2 (1 d ) (1 d ) (1 d )3 d 1159% .

IRR and NPV

HP 10B Keystokes

CL E A R A L L 1 1 0 0 ,0 0 0 2 0 ,0 0 0 3 5 ,0 0 0 7 5 ,0 0 0 P/ YR

+/CFj CFj CFj

CFj

IR R / Y R

Clears registers One payment per year Initial CF = - $100,000 1st CF = $ 20,000 2nd CF = $ 35,000 3rd CF = $ 75,000 Compute yield (IRR)

IRR and NPV

Example: NPV for uneven cash flows. What is the NPV for an investment that costs $10,000 today, $8,000 one year from today, $5,000 two years from today and pays $15,000 three years from today and $25,000 four years from today if future cash flows are discounted at 10%?

$8,000 $5,000 $15,000 $25,000 NPV $10,000 2 3 11 . 11 . 11 . 114 .

NPV = -$10,000 - $7,272.73 - $4,132.23 + $11,269.72 + $17,075.34 = $ 6,940.10

IRR and NPV

HP 10B Keystrokes
CL E A R A L L 1 P/ YR CFj CFj CFj

1 0 ,0 0 0 +/8 ,0 0 0

+/+/CFj CFj

5 ,0 0 0 1 5 ,0 0 0 2 5 ,0 0 0 10

I/ Y R N PV

Clear registers One payment per year Initial CF = - $ 10,000 1st CF = - $ 8,000 2nd CF = - $ 5,000 3rd CF = $ 15,000 4th CF = $ 25,000 Discount rate = 10% Compute net present value

IRR and NPV

Example: IRR for grouped cash flows. Compute the IRR for an investment that costs $92,725.60 today and is expected to pay $10,000 at the end of the year for the next three years; $15,000 at the end of years 4 and 5; and $100,000 at the end of year 6.
$10,000 5 $15,000 $100,000 $92,725.60 t t (1 d ) (1 d ) (1 d )6 t 1 t 4
d = 12%
3

IRR and NPV

HP 10B Keystrokes
CL E A R A L L 1 P/ YR CFj

9 2 ,7 2 5 .6 0 +/1 0 ,0 0 0 CFj 3 1 5 ,0 0 0 2 N j CFj N j

1 0 0 ,0 0 0 CFj IR R / Y R

Clears registers One payment per year Initial CF = - $ 92,725.60 1st grouped CF = $ 10,000 Occurs three times 2nd grouped CF = $ 15,000 Occurs twice 3rd CF = $ 100,000 (once) Compute the yield (IRR)

IRR and NPV

Example: NPV for grouped cash flows. Compute the NPV for an investment that costs $98,000 today and is expected to pay $791.38 at the end of each month for 12 months; $850.73 at the end of each month for the following 12 months; $914.54 at the end of each month for the following 11 months and a balloon payment of $107,491.18 at the end of month 36 if the investor discounts future cash flows monthly at a 13% annual rate.

NPV = - $554.17 = - $98,000 +

24 35 1 1 1 $107,49118 . $791.38 $850.73 $914.54 013 t . 013 t . 013 t . 013 36 . t 1 (1 t 13 (1 t 25 (1 ) ) ) (1 ) 12 12 12 12 12

IRR and NPV

HP 10B Keystrokes
CL E A R A L L 12 9 8 ,0 0 0 7 9 1 .3 8 12 8 5 0 .7 3 12 9 1 4 .5 4 11 P/ YR

+/C Fj N j C Fj N j C Fj N j

C Fj

1 0 7 ,4 9 1 .1 8 13

C Fj

I/ Y R N PV

Clear registers Monthly payments Initial CF = - $98,000 1st grouped CF = $791.38 Occurs 12 times 2nd grouped CF = $850.73 Occurs 12 times 3rd grouped CF = $914.54 Occurs 11 times 4th CF = $107,491.18 (once) Discount rate = 13% Compute net present value