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Lecture III: Finish Discounted Value Formulation

I. Internal Rate of Return A. Formally defined: Internal Rate of Return is that interest rate which reduces the net present value of an investment to zero. 1. Finding the internal rate of return : The solution of the internal rate of return does not analytically exist. Methods for finding the internal rate of return are, thus, numerical search techniques or iterative processes. a. Simple approach: Numeric gradient (i.) Compute the NPV of an investment at two points, or for two interest rates. {The solution technique works best if one point has a positive NPV and the other a negative NPV}. (ii.) Compute the line between the two points and find where the line equals zero. Assume i2 >i1 and NPV1 >NPV2 . NPV1 NPV2 i3 = i1 i1 i1 i2
or NPV1 NPV2 i3 = i2 i2 i1 i2

NPV

i3 i1

i2

(iii.)

Decide whether the NPV is close enough to zero-Stop if yes, go back to step (ii) if no. {If the NPV at i3 is positivereplace i1 , if it is negative, replace i2 }.

AEB 6145 Lecture III Professor Charles B. Moss Problems: The procedure does not have a good convergence {it may take a long time}. It may be difficult to find a good starting place-you need two interest rates that bound the zero (one positive NPV and another with a negative NPV). (v.) Advantage: It is robust- it will always work. b. Newtons Method NPV ( ik ) ik +1 = ik NPV ( i) i i =i
k

(iv.)

(i.)

For a reference to Newtons method see Burington, R. S. Handbook of Mathematical Tables and Formulas Fifth Edition (New York: McGraw-Hill Book Company, 1973): 189. See also my lecture notes on Newtons Method from AEB 6533. http://128.227.113.61/chuck/aeb6533.mathprogramming/l ecture9.pdf. N NCFt NPV ( i) = t t =0 (1 + i ) NPV ( i ) i = t
t =1 N

(1 + i )

NCFt

t 1

=
t =1

(1 + i )

tNCFt

t 1

(ii.) (iii.) (iv.) (v.)

Choose an initial i. Apply the formula to compute a new i. Check to see if the NPV is close to zero. If no reiterate, if yes stop. This technique is similar to the first, except an analytical slope is substituted for the numerical slope.

AEB 6145 Lecture III Professor Charles B. Moss

NPV

i1

i2 i3

Comments: This method is relatively quick and is robust if the net cash flows are smooth. Unfortunately, it is possible to stick the algorithm and it may break down if NPV has multiple optimum. B. Why is it wrong to IRR. 1. Remember that the IRR is simply the i that reduces the NPV to zero. I want to show that: a. Under certain conditions IRR and NPV yield the same results, i.e. in the case of conventional investments. b. I can show that under certain conditions IRR yields an inferior investment decision that NPV correctly identifies. c. Thus, NPV dominates IRR as an investment criteria. 2. Assume that Big Green manufacturing comes out with a lease system that charges lease payments for 3 years and then requires the investor to purchase the machine. This machine generates revenue with cash flows. The total cash flows for the investment are presented in table 1. Table 1. Cash Flows for Big Green Machinery Investment Year Cash Flow 0 750 1 750 2 1,000 3 1,250 4 -15,000 The IRR for this investment is .7014 and the NPV at a discount rate of 5% is 898.14. Next, I want to generate the unrecovered balance for 3

(vi.)

AEB 6145 Lecture III Professor Charles B. Moss the investment in each year. The unrecovered balance is defined like a savings account. Departing from the investment example in table 1, consider an investment with a normal cash flow pattern as depicted in table 2. Table 2. Unrecovered Balance for Investment with Normal Cash Flow Patterm Interest Cash on Unrecovered Year Flow Balance Balance 0 -15000.00 -15000.00 1 5000.00 -750.00 -10750.00 2 5000.00 -537.50 -6287.50 3 5000.00 -314.38 -1601.88 4 5000.00 -80.09 3318.03 As presented in table 2, the year 0 cash flow for this investment is 15,000 (corresponding with an initial investment). At the end of year 0 (beginning of year 1) this negative cash flow would have accrued an interest chare of 750. Adding the positive cash flow in period 1 (5,000) to the interest charge and the unrecovered balance of 15,000 yields an unrecovered balance at the beginning of period 1 of 10,750. Applying this technique to cash flows in table 1, but using two interest rates (5% as in NPV and .7014 as in the IRR). Table 3. Unrecovered Balance Using Two Interest Rates. Unrecovered Unrecovered Year Cash Flow Balance .7014 Balance .05 0 750 1,276 788 1 750 3,447 1,614 2 1,000 7,566 2,745 3 1,250 15,000 4,195 4 -15,000 0 -10,805 The higher the ending balloon payment, the higher the IRR and the lower the NPV also the more undesirable the investment. 3. There exist certain legitimate investment questions for which the IRR does not exist. a. For the IRR to exist both positive and negative cash flows must occur. However, several important and relevant investments may exist that have all negative or all positive cash flows. b. Examples: (i.) All negative cash flows: Suppose a farmer is evaluating the purchase of two tractors. Also assume that he is not currently constrained in tractor time so that the additional revenue of either tractor is zero. The farmer wants a technique that chooses the tractor with the least cost through time.

AEB 6145 Lecture III Professor Charles B. Moss Table 4. Comparison of Tractor Costs Year Tractor I Tractor II 0 -15,000 -10,000 1 -250 -100 2 -250 -200 3 -700 -1,000 4 -1,250 -1,500 5 -1,500 -2,000 NPV at 5% -18,950 -14,800 (ii.) No negative cash flows and the extremely profitable investment. Table 5. No Negative Cash Flows and an Extremely Profitable Investment Year No Negative Extremely Cash Flows Profitable 0 0 -100 1 100 200 2 200 400 3 300 600 4 400 800 IRR 268.63 8 NPV 1,629.75 864.88 C. Conclusions 1. IRR is defined as the discount rate that reduces the NPV of an investment to zero. 2. Problems: a. It does not handle mixed investment flows appropriately. b. It may not exit or may have several IRRs.