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Chapter 12: Discounting and Depreciation Formulas 325

Figure 12-8: Calculating the NPV using quarterly cash flows.

For an illustration of the difference that can result from different frequencies, see Figure 12-9. It
shows the same data, but this time, the calculations are based on the assumption that the rent of
$48,000 per annum is paid annually in arrears. Still discounting at 7% per annum effective, you
get an NPV of $160,635.26. The formula in cell D32 is

=NPV(C3,D27:D30)*(1+C3)

Figure 12-9: Calculating the NPV by annualizing quarterly cash flows.

Using the NPV function to calculate accumulated amounts


This section presents two examples that use the NPV function to calculate future values or accu-
mulations. These examples take advantage of the fact that

FV = PV * (1 + Rate)^nper

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326 Part III: Financial Formulas

Calculating future value


The data for this example is shown in Figure 12-10. The NPV calculation is performed by the for-
mula in cell B15:

=NPV(B3,B7:B13)+B6

The future value is calculated using the following formula (in cell B17):

=(NPV(B3,B7:B13)+B6)*(1+B3)^7

Figure 12-10: Calculating FV using the NPV function.

The result is also computed in column D, in which formulas calculate a running balance of the
interest. Interest is calculated using the interest rate multiplied by the previous month’s balance.
The running balance is the sum of the previous balance, interest, and the current month’s cash
flow.
It is important to properly sign the cash flows. Then, if the running balance for the previous
month is negative, the interest will be negative. Signing the flows properly and using addition is
preferable to using the signs in the formulas for interest and balance.

Smoothing payments
Chapter 11 covers the use of the PMT function to calculate payments equivalent to a given pres-
ent value. Similarly, you can use the NPV function, nested in a PMT function, to calculate an
equivalent single-level payment to a series of changing payments.
This is a typical problem where you require a time-weighted average single payment to replace a
series of varying payments. An example is an agreement in which a schedule of rising rental pay-
ments is replaced by a single-level payment amount. In the example shown in Figure 12-11, the

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Chapter 12: Discounting and Depreciation Formulas 327

following formula (in cell C25) returns $10,923.24, which is the payment amount that would sub-
stitute for the varying payment amounts in column B:

=PMT(C5,C4,–B23,0,C6)

Figure 12-11: Calculating equivalent payments with NPV.

Using the IRR Function


Excel’s IRR function returns the discount rate that makes the NPV of an investment zero. In other
words, the IRR function is a special-case NPV.
The syntax of the IRR function is

IRR(range,guess)

The range argument must contain values. Empty cells are not treated as zero. If the
range contains empty cells or text, the cells are ignored.

In most cases, the IRR can be calculated only by iteration. The guess argument, if supplied, acts
as a “seed” for the iteration process. It has been found that a guess of –90% will almost always
produce an answer. Other guesses, such as 0, usually (but not always) produce an answer.

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328 Part III: Financial Formulas

An essential requirement of the IRR function is that there must be both negative and positive
income flows: To get a return, there must be an outlay, and there must be a payback. There is no
essential requirement for the outlay to come first. For a loan analysis using IRR, the loan amount
will be positive (and come first), and the repayments that follow will be negative.
The IRR is a very powerful tool, and its uses extend beyond simply calculating the return from an
investment. This function can be used in any situation in which you need to calculate a time- and
data-weighted average return.

The examples in this section are in a workbook named internal rate of return.
xlsx, which is available on the companion CD-ROM.

Rate of return
This example sets up a basic IRR calculation (see Figure 12-12). An important consideration when
calculating IRR is the payment frequency. If the cash flows are monthly, the IRR will be monthly.
In general, you’ll want to convert the IRR to an annual rate. The example uses data validation in
cell C3 to allow the user to select the type of flow (annual, monthly, daily, and so on), which dis-
plays in cell D3. That choice determines the appropriate interest conversion calculation; it also
affects the labels in row 5, which contain formulas that reference the text in cell D3.

Figure 12-12: The IRR returns the rate based on the cash flow frequency and should be converted into an
annual rate.

Cell D20 contains this formula:

=IRR(D6:D18,–90%)

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Chapter 12: Discounting and Depreciation Formulas 329

Cell D21 contains this formula:

=FV(D20,C3,0,–1)–1

The following formula, in cell D23, is a validity check:

=NPV(D20,D7:D18)+D6

The IRR is the rate at which the discounting of the cash flow produces an NPV of zero. The for-
mula in cell D23 uses the IRR in an NPV function applied to the same cash flow. The NPV dis-
counting at the IRR (per month) is $0.00 — so the calculation checks.

Geometric growth rates


You may have a need to calculate an average growth rate, or average rate of return. Because of
compounding, a simple arithmetic average does not yield the correct answer. Even worse, if the
flows are different, an arithmetic average does not take these variations into account.
A solution uses the IRR function to calculate a geometric average rate of return. This is simply a
calculation that determines the single percentage rate per period that exactly replaces the vary-
ing ones.
This example (see Figure 12-13) shows the IRR function being used to calculate a geometric aver-
age return based upon index data (in column B). The calculations of the growth rate for each
year are in column C. For example, the formula in cell C5 is

=(B5/B4)–1

The remaining columns show the geometric average growth rate between different periods. The
formulas in Row 10 use the IRR function to calculate the internal rate of return. For example, the
formula in cell F10, which returns 5.241%, is

=IRR(F4:F8,–90%)

In other words, the growth rates of 5.21%, 4.86%, and 5.66% are equivalent to a geometric aver-
age growth rate of 5.241%.
The IRR calculation takes into account the direction of flow and places a greater value on the
larger flows.

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