Time Value of Money

Professor Pavle Radicevic

PhD UNSW, Sydney
Perfect Markets

For most of the course, we will pretend to live in a so-called perfect

market. Such a perfect world satisfies 4 assumptions:
1. No differences in opinion.
– This assumption allows for uncertainty, as long as everyone
agrees what exactly it is. This assumption implies no
difference in the information set among agents.
2. No taxes.
– Also no government interference and regulation—except
costless property rights.
3. No transaction costs.
4. No big sellers/buyers.
– Of any special investor or firm group, there are infinitely
many clones that can buy or sell.
2
Additional Assumption for today

In this lecture, we also additionally assume:

• perfect certainty
– Thus, we know the rates of return on every project in each
period.

3
Rates of Return
The rate of return from investing Co at time 0 and getting C1 at time 1 is:

C1  C 0 C1
r  r 0,1   1
C0 C0
With dividends D (or coupons or rent) paid at the end of the period (thus not
reinvestable to get you even more):

C1  D 0,1  C 0 C1  D 0,1
r  r 0,1   1
• The dividend (or coupon or interim
C 0 payment) yield
C 0is D0,1/C0 .
• The capital gain is C1 – C0.
• The (percent) price change is (C1 − C0) ⁄ C0 (multiplied by 100)
• The (total) rate of return is the percent price change plus the interim payment
yield.

4
The One-Period Case: Future Value
• If you were to invest $10,000 at 5-percent interest for
one year, your investment would grow to $10,500.
• Thus, the future value of investing C0 today at interest
rate r is:
FV = C0×(1 + r)
This multiplication is called “compounding”
• A (sure) dollar today is not equal to a (sure) dollar
tomorrow because there exists an outside opportunity:
to invest at r!

5
The One-Period Case: Present Value
• If you were promised $10,000 due in one year when
interest rates is 5-percent, how much would your
investment be worth in today’s $?
How much do you need to invest today to get
$10,000 in a year?
$10,000
$9,523.81 
1.05
• Thus, the present value of a payoff next period is:
C1
PV 
 (1 r)
This division is called “discounting” 6
The Multi-period Case: Future Value
• The general formula for the future value of an investment
over many periods (at constant interest rate) can be written
as:
FV = C0×(1 + r)T
Where
C0 is cash flow at date 0,
r is the appropriate interest rate, and
T is the number of periods over which the cash is invested.
Excel function: FV

7
The Power of Compounding
Dutch bought Manhattan for $24 in 1626.

• At 1% for 390 years

FV =$24*(1+0.01)390 = $24*(48)

• At 10% for 390 years

FV =$24*(1+0.1)390 = $24*(13904 Trillion)

8
222 years of US Interest rates
(source: Louise Yamada / Yahoo Finance)

9
How Long is the Wait?

If we deposit $5,000 today in an account paying 10%, how

long does it take to grow to $10,000?

FV  C0  (1  r )T
ln( FV / C 0) ln 2 0.6931
T    7.27 years
ln(1  r ) ln(1.10) 0.0953
Excel function: NPER

“Rule of 72”: years to double ≈ 72 / r

(fairly accurate for r > 2%)

10
What Rate Is Enough?

Assume the total cost of a college education will be

$50,000 when your child enters college in 20 years.
What rate of interest must you earn on your investment to
cover the cost of your child’s education if you only have
$5,000 to invest today?

FV  C0  (1  r )T
FV 1/ T
r ( )  1  101 20  1  0.122
C0
Excel function: RATE

11
Compounding Periods
Compounding an investment m times a year for T years
provides for future value of wealth:
mT
 r
FV  C0  1  
 m

For example, if you invest $100 for 3 years at 12%

compounded semi-annually, your investment will
grow to
23
 .12 
FV  $100  1    $100  (1.06)  $141.85
6

 2 
12
Continuous Compounding

• The general formula for the future value of an

investment compounded continuously over many
periods can be written as:
FV = C0×erT
Where
C0 is cash flow at date 0,
r is the stated annual interest rate,
T is the number of periods over which the cash is invested, and
e is a transcendental number ≈ 2.718.

13
EAR/EAY/APY vs APR
APR does not take compounding into account (it is a
simple interest rate), while EAR does.
m
 APR 
1  EAR  1  
 m 

EAR for a 6% APR with different compounding:

Annual (1+0.06)1-1=6%
Semiannual (1+0.06/2)2-1=6.09%
Monthly (1+0.06/12)12-1=6.1678%
Daily (1+0.06/365)365-1=6.1831%
Continuously e0.06-1=6.1837%
14
 Valuing Multiple Cash Flows

• In reality, the cash flows from the investment

spread over many periods, so present value of
future cash flows can be computed as:

C1 C2 C3
PV    
(1  r ) (1  r ) (1  r )
2 3

• Or Net Present Value of your investment is:

C1 C2 C3
NPV  C0    
(1  r ) (1  r ) (1  r )
2 3

15
The Simplest (Financial) Instruments

• Perpetuity
– A constant stream of cash flows that lasts forever.
• Growing perpetuity
– A stream of cash flows that grows at a constant rate forever.
• Annuity
– A stream of constant cash flows that lasts for a fixed number
of periods.
• Growing annuity
– A stream of cash flows that grows at a constant rate for a
fixed number of periods.

16
Perpetuity

A constant stream of cash flows that lasts forever.

C C C
…
0 1 2 3
C C C
PV    
(1  r ) (1  r ) (1  r )
2 3

The formula for the present value of a perpetuity is:

C
PV 
r
17
Growing Perpetuity

A growing stream of cash flows that lasts forever.

C C×(1+g) C ×(1+g)2
…
0 1 2 3

C C  (1  g ) C  (1  g ) 2
PV    
(1  r ) (1  r ) 2
(1  r ) 3

The formula for the present value of a growing perpetuity is:

C
PV 
rg
18
Annuity
A constant stream of cash flows with a fixed maturity.
C C C C

0 1 2 3 T

C C C C
PV    
(1  r ) (1  r ) (1  r )
2 3
(1  r ) T

The formula for the present value of an annuity is:

C 1 
PV  1  T 
r  (1  r ) 
19
Annuity: Example

If you can afford a 30K monthly car payment, how

expensive your future car can be if interest rates are 7%
on 36-month loans?
30K 30K 30K 30K

0 1 2 3 36
30000  1 
PV  1 36 
 971,594
0.07 / 12  (1  0.07 12) 
Excel: 971594 =PV(0.07/12, 36, -30000, 0, 0)
Or: 30000 =PMT(0.07/12, 36, -971594, 0, 0)

20
Question for Self-Assessment

Suppose you borrow 971,594 from the bank at 7% for 3 years with
monthly repayments.
From the example above we know that each month you have to
give 30K to the bank.
This comprises of both the interest payment (interest on the loan
outstanding) and principal repayment.

Calculate the exact schedule of interest and principal

payments for each month (i.e. how much of this 30K is
interest and how much is principal each month).
(If you’ve done this correctly, after the last 30K the outstanding
loan should equal 0).
How is this schedule helpful?

21
Period Total Payment Interest Paid Principal Paid Outstanding Principal
0 971593.93
1 30000 5667.63 24332.37 947261.56
2 30000 5525.69 24474.31 922787.26
3 30000 5382.93 24617.07 898170.18
4 30000 5239.33 24760.67 873409.51
5 30000 5094.89 24905.11 848504.40
6 30000 4949.61 25050.39 823454.01
7 30000 4803.48 25196.52 798257.49
8 30000 4656.50 25343.50 772913.99
9 30000 4508.66 25491.34 747422.66
10
11 30000
30000 4359.97
4210.40 25640.03
25789.60 721782.62
695993.02
12
13 30000
30000 4059.96
3908.64 25940.04
26091.36 670052.98
643961.62
14
15 30000
30000 3756.44
3603.36 26243.56
26396.64 617718.06
591321.42
16
17 30000
30000 3449.37
3294.50 26550.63
26705.50 564770.79
538065.29
18
19 30000
30000 3138.71
2982.02 26861.29
27017.98 511204.00
484186.03
20
21 30000
30000 2824.42
2665.89 27175.58
27334.11 457010.45
429676.34
22
23 30000
30000 2506.45
2346.07 27493.55
27653.93 402182.79
374528.85
24
25 30000
30000 2184.75
2022.50 27815.25
27977.50 346713.60
318736.10
26
27 30000
30000 1859.29
1695.14 28140.71
28304.86 290595.39
262290.53
28
29 30000
30000 1530.03
1363.95 28469.97
28636.05 233820.56
205184.52
30 30000 1196.91 28803.09 176381.43
31 30000 1028.89 28971.11 147410.32
32 30000 859.89 29140.11 118270.21
33 30000 689.91 29310.09 88960.12
34 30000 518.93 29481.07 59479.05
35 30000 346.96 29653.04 29826.01
36 30000 173.99 29826.01 0.00
22
Growing Annuity
A growing stream of cash flows with a fixed maturity.
C C×(1+g) C ×(1+g)2 C×(1+g)T-1

0 1 2 3 T
T 1
C C  (1  g ) C  (1  g )
PV   
(1  r ) (1  r ) 2
(1  r )T
The formula for the present value of a growing annuity:

C   1 g  
T

PV  1    
r  g   (1  r )  
  23
Recap: 4 simplifying formulas

C
Perpetuity : PV 
r
C
Growing Perpetuity : PV 
rg

C 1 
Annuity : PV  1 
r  (1  r )T 

C   1 g  
T

Growing Annuity : PV  1    
r  g   (1  r )  
 
24
Bonds (Облигации)

• A bond is a security sold by the government or a

corporation to raise money from investors today in
exchange for a promised future payment.

• It is a legally binding agreement between a borrower

and a lender that:
– Specifies the principal of the loan amount
– And the size and timing of the cash flows:
• In currency terms (fixed-rate borrowing)
• As a formula (floating-rate borrowing)

25
Example of a Level-Coupon Bond
• Consider a U.S. government bond listed as 1 3/8 of April 30, 2021.
– The Par Value (Face Value) of the bond is $100.
– Coupon payments are made semi-annually (April 30 and October
31 for this particular bond).
– Since the coupon rate is 1 3/8 the coupon payment is
100*0.01375/2= $0.6875.
– On May 1, 2016 the size and timing of cash flows are:

$0.6875 $0.6875 $0.6875 $100.6875


05 / 1 / 16 10 / 31 / 16 04 / 30 / 17 10 / 31 / 20 04 / 30 / 21

26
Pure Discount (Zero-Coupon) Bonds

– Time to maturity (T) = Maturity date - today’s date

– Face value (F)
– Discount rate (r)

$0 $0 $0 $F

0 1 2 T 1 T

Present value of a pure discount bond at time 0:

F
PV  T
(1 r)
27
Pure Discount Bonds: Example

Find the value of a 30-year zero-coupon bond with a $100 par

value and the discount rate is 6%.

$0 $0 $0 $100 0


0 1 2 29 30

How much are you willing to pay for this bond?

F $100
PV    $17.41
(1  r ) T
(1.06) 30

28
No Arbitrage Price of a Security

If the price of the bond is not equal to $17.41, there is an

arbitrage opportunity.
So $17.41 is the no-arbitrage price of the bond.
In a perfect world:
Price(Security) = PV (All cash flows paid by the security)

This means that investing in financial securities is a “zero-

NPV” project:

NPV  Price  PV(all future cash flows)  0

29
 Solving for r: Yield to Maturity

YTM is the discount rate that makes PV(promised future bond

payments) equal to the current market price of the bond.
This is the rate of return that you will earn if you buy the bond
at current market price and hold it to maturity.

What information is available? P

$100
 $17.41
(1  YTM ) 30
The price of a 30-year zero- $100
coupon bond with a $100 par (1  YTM ) 30 
$17.41
value is $17.41. $100
1 / 30
YTM   1  6%
$17.41

30
Level-Coupon Bond
Find the price (as of May 1, 2016) of the 1 3/8 level-coupon bond
with face value $100 if the YTM is 1.5%:
It is an annuity that pays 0.6875. every 6-month for 10 times and
repays the principal in 5 years:

$0.6875 $0.6875 $0.6875 $100.6875


05 / 1 / 16 10 / 31 / 16 04 / 30 / 17 10 / 31 / 20 04 / 30 / 21

$0.6875  1  $100
PV  1 10 
 10
 $99.40
.015 2  (1.0075)  (1.0075)
31
If interest rates are flat (constant)

Value of a Level-coupon bond

= PV of coupon payment annuity + PV of face value

C 1  F
P  1  T 

r  (1  r )  (1  r )T

32
Plug-in and Rearrange

Coupon payment (C)= coupon rate (c) * Face value (F)

CF  1  F
P 1  (1  YTM )T   (1  YTM )T
YTM  

 1  C
P  F  F 1  T 
(  1)
 (1  YTM )  YTM
If the coupon rate is higher than the YTM, then P>F
(premium bond): you need to have a capital loss to make total return
equal YTM.
If the coupon rate is lower than the YTM, then P<F
(discount bond): you need to have a capital gain to make
total return equal YTM.
33
Current bond quotes from Bloomberg

34
Interest rates fluctuate…

… And so will bond prices.

• Bond prices and market interest rates move in opposite

directions.
• As interest rates in the economy rise, yields that investors
demand for investing in bonds rise as well (YTM increases and
price of the bond falls).
– You just bought a bond (lent money), and YTM increases. You could have
lent at a higher rate!

• The sensitivity of interest rate movements is higher for bonds of

higher duration (that pay more cash flows in the distant future):
longer time-to-maturity, lower coupon payments

35
Figure 8.2 BD:

Yield to
Maturity and
Bond Price
Fluctuations
Over Time

36
Questions for Self-Assessment

• If you purchase a house and live in it, what are the relevant
inflows and outflows?

• A tall Starbucks coffee costs 250R a day. If the bank’s quoted

interest rate is 6% per annum, compounded daily, and if the
Starbucks price never changed, what would an endless,
inheritable free subscription to one Starbucks coffee per day be
worth today?

• VTB Bank raised $1 bln in 2012 by issuing a perpetuity at

YTM=9.5%. What was the promised (semi-annual) coupon?
*in reality there was also an option to redeem the bond (“call”) before maturity, but
you will learn how to price it in the derivatives class

37
Time-Varying Rates of Returns
Important: All earlier formulas hold.

• The only difference is that

• The main complication is that we are now in subscript
hell. We need one subscript (well, two) for each
period. (1  r 0,3)  (1  r 0,1)  (1  r1, 2)  (1  r 2,3)

• For example C1 C2 C3
NPV  C 0   
(1  r 0,1) (1  r 0, 2) (1  r 0,3)

C1 C2 C3
 C0   
(1  r 0,1) (1  r 0,1)  (1  r1, 2) (1  r 0,1)  (1  r1, 2)  (1  r 2,3)

38
Annualized Rates of Returns

• It is hard to compare interest rates if the length of the periods

varies. So need a standardized form by which we can compare,
e.g., 3-day, with 5-year interest rates.
• Almost all interest rates are quoted as annualized.
• Annualized interest rate takes into account compounding.
• If the holding period return over t years is then annualized
r0,t
rate of return is

1  rt  1  r0,t 
1/ t

• Annualized interest rates are (often just a little) below average

interest rates, because they take into account the interest on
interest (they are a geometric average).

39
The Yield Curve and Treasuries

• U.S. Treasuries are one of the most important financials markets in the world.
– They are risk-free.
– The outstanding amount is >$19 trillion
about half held by foreign investors
– Names: Bills (<=1y), Notes (2y-10y), Bonds (>10y).
• This market is close to “perfect”:
– Extremely low transaction costs (for traders).
– Few opinion differences (inside information).
– Deep market: many buyers and sellers.
– Income taxes depend on owner.
• In addition, there is no uncertainty about payment.
(Note, a market could still be perfect, even if payoffs are uncertain).

40
Yield Curve as of May 23, 2016

The YC is a fundamental tool of finance. It always graphs

annualized rates. It measures differences in the costs of capital for
(risk-free) projects with different horizons.
41
Why Upward Sloping Yield Curves (Normally)?

If long-term bonds offer higher rate, why doesn’t everybody buy

them?

Even “risk-free” bonds do not guarantee fixed rate of return over

horizons shorter than their maturities.

Prices of long-term bonds fluctuate much more than of short-term

bonds: they are more sensitive to interest rate changes. Investors
do not like price fluctuations – long-term bonds earn a “risk
premium”.

Expectations of higher interest rates in future: when a short-term

bond matures, you can reinvest the proceeds at a higher rate,
which may be enough to offset lower yield of the original bond.

42
Corporate Lesson

• A project of x years is not simply the same as investing in x

consecutive 1-year projects. From an investment perspective,
they are different animals, and can require different costs of
capital.

• The fact that longer-term projects may have to offer higher

rates of return (could but) need not be due to higher risk.
Even default-free Treasury bond projects in the economy that
are longer-term have to offer higher rates of return than
default-free Treasury bond projects in the economy that are
shorter term.

• Of course, long-term projects are also often riskier (more

default), and this may eventually also help explain why long-
term projects have to offer higher rates of return.

43
Note: Spot and Forward Rates

We call a currently prevailing interest rate for an investment starting today a

spot interest rate. Like all other interest rates, spot rates are usually quoted
in annualized terms.

We denote an annualized interest rate over 15 years as . This contrasts

r15 with
the 15-year non-annualized holding interest rates, denoted as r0,15.

(1  r15)15  (1  r 0,15)  (1  r 0,1)  (1  r1, 2)   (1  r14,15)

(1  r t )t  (1  r 0, t )
A forward rate is an interest rate that will be applicable in the future
The interest rate from period 1 to period 2 is called the 1-Year Forward
(Interest) Rate from Year 1 to Year 2.
In a world of certainty, the forward rate will be the future spot rate.
In the real world, you can lock it today, even if it will not be the future spot
rate.

44
Note: Nominal or Real?

45
Dividend Discount Model

46
Value of a stock
• Book value of equity (per share)?
– Historic cost: what company paid for assets (less
depreciation)

• Liquidation value?
– What the company could get by selling its assets and
repaying its debts.

• Market value!
• Treats the firm as a going-concern.

47
Present Value of Common Stocks
• Expected return on a stock for a 1-year investor:
Div1  P1  P0 Div1 P1  P0
r  
P0 P0 P0
dividend yield capital gain
Div1  P1
• If P0  1  rE , expected return on this stock is lower than on
others of equivalent risk (rE), so demand for this stock will
decrease and price will adjust downwards.
Div1  P1
P0 
• If 1  rE , expected return on this stock is higher than on
others of equivalent risk (rE), so demand for this stock will
increase and price will adjust upwards.

48
Present Value of Common Stocks
• “Correct” pricing: expected total return on a stock ( r ) equals
the expected return on other investments with similar risk (rE) –
the opportunity cost of equity capital.

Div1  P1
• Then P0  , where rE is the required rate of return.
1  rE

• Recall: in a perfect market trading a financial security is a “zero-

NPV” project:

Div1  P1
NPV   P0  0
1  rE

49
Present Value of Common Stocks

Div1  P1 Div 2  P2
P0  and P1  , etc
1  rE 1  rE

Div1 Div 2 Div t

• Then P0    ...   ...
1  rE (1  rE ) 2
(1  rE ) t

• I.e. to value the common stocks we need to value the

stream of dividends.

• This is the general dividend-discount model.

50
Case 1: Zero Growth
• Assume that dividends will remain at the same level
forever
Div1  Div 2  Div 3  
• Since future cash flows are constant, the value of a zero
growth stock is the present value of a perpetuity:

Div1 Div 2 Div 3

P0    
(1  rE ) (1  rE ) (1  rE )
1 2 3

Div1
P0 
rE

51
(Gordon Growth Model)

• Assume that dividends will grow at a constant rate, g,

forever. i.e. Div 1  Div 0 (1  g )

Div t  Div t 1 (1  g )  Div 0 (1  g ) t

• Since future cash flows grow at a constant rate forever,

the value of a constant growth stock is the present value
of a growing perpetuity:

Div1
P0 
rE  g
52
Problems with constant growth
• Recall that the valuation formula becomes meaningless
as growth rate g approaches the discount rate rE

• Dividends are very unstable

• In reality, the growth slows down after firms pass the

growth stage and become the “cash cows” or “value
firms”.

53
Most common case: Differential Growth
• Assume that dividends will grow at different rates in the
foreseeable future and then will grow at a constant rate
thereafter.
• To value a Differential Growth Stock, we need to:
– Estimate future dividend growth in near future
– Estimate future dividend growth as it leaves the
growth stage
– Compute the total present value at the appropriate
discount rate.

54
Dividend-Discount Model
• The reason why Dividend Discount Model is used less
often than Discounted Cash Flows Model: its
underlying parameters are difficult to
predict/estimate.
• The value of a firm depends upon its growth rate, g, and
its discount rate, rE.
– Where does rE come from?
– Where does g come from?

55
Where does g come from? Example
• Current earnings are $100
• Retention/plowback ratio is 40% , i.e. dividend payout
ratio is 60%, meaning that $40 is reinvested and $60 is
dividend.
• Firm earns 25% return on the reinvested earnings by
selecting profitable projects, thus $40 will produce $10
of extra earnings next year.
• Again, 60% of $100+$10 is paid out, resulting in 10%
dividend growth from $60 to $66
• Growth of dividend = 40%*25%=10%

56
Where does g come from? Example

Div Div
payout  retention  1 
EPS EPS
Div0  payout  EPS0
Div1  payout  EPS1
EPS1  EPS0  ( EPS0  Div0 )  R
EPS1  EPS0 (1  retention R)

Div1  Div0 EPS1  EPS0

g   retention R
Div0 EPS0

g  retention R
57
Pay out or plow back?

• Is the payout ratio of 60% optimal?

• Should you reduce the dividend (payout ratio) and
instead invest more?

Div1 60
• Current share price is: P0    600
(assume rE=0.2) rE  g 0.2  0.1

• New policy (reduce payout to 30%):

Div1 30
P0    1200
rE  g 0.2  0.7 * 0.25

• What if the cost of equity were 0.3?

58
Pay out or plow back?

• Current share price is: Div1 60

P0    300
(assume rE=0.3) rE  g 0.3  0.1

• New policy (reduce payout to 30%):

Div1 30
P0    240
rE  g 0.3  0.7 * 0.25
• Whether stock price rises or falls depends on whether
the return on reinvested earnings (ROE of new
investments) is lower or higher than the required return
on equity.
• CL: Cutting dividend to increase investment raises
stock price iff the new investments have positive NPV.
59
Summary and Conclusions

• The growth rate can be estimated as: g=retention*R

– The basic intuition behind this estimate is that the firm that fails to
reinvest part of its profit will eventually stop growing and therefore is
expected to produce g=0.
– The assumption is that the firm will eventually pay its value in
dividends.
– The above formula is almost as far as we can go in predicting dividend
growth.

• Can’t use it to value firms that are not paying any dividends
now.
• Hard to predict dividend growth (often at managerial
discretion).
• CL: We’ll have to go back to fundamentals and figure out
where dividends come from – the cash flows.
60
Question for Self-Assessment

In a world of perfect markets and no uncertainty does it make more

sense to invest in a public company that grows quickly or slowly
(otherwise identical)?

(check the example on p.32 of Welch)

61
Alternative Investment Rules

62
Investment Rules

• Net Present Value

• The Internal Rate of Return
• The Profitability Index
• The Payback Period
• The Discounted Payback Period
• The Average Accounting Return

63
Real Life Capital Budgeting

Rarely means “usually no—often used incorrectly in the real world.” NPV works if
correctly applied, which is why there is a qualifier “almost” to always. Of course, if
you are considering an extremely good or an extremely bad project, almost any
evaluation criterion is likely to give you the same recommendation.

Source: Graham and Harvey, 2001.

64
The Net Present Value (NPV) Rule

• NPV = PV of all future CF’s – Initial Investment

C1 C2 C3
NPV  C 0    
(1  r ) (1  r ) (1  r )
2 3

• Estimating NPV:
– 1. Estimate future cash flows: how much? and when?
– 2. Estimate discount rate, r, (cost of capital)
– 3. Estimate initial costs

• Minimum Acceptance Criteria: Accept if NPV > 0

• Mutually exclusive projects: Choose the highest NPV

65
Why Use Net Present Value?

• In perfect markets under certainty, a positive NPV project is

equivalent to an “arbitrage:” money for nothing
–Under uncertainty we will use an appropriate discount rate to reflect risky
cash flows, so NPV>0 will still mean better than market opportunities.
–Importantly: pocketing NPV does not depend on your future ability to
reinvest cash flows at r. Only at investing (borrowing) today at r.
• Any alternative rule must simplify back to NPV when financial
markets become more perfect and uncertainty becomes less (and
you can account for them in NPV).
Important advantages of NPV:
1. Uses cash flows
2. Uses ALL cash flows of the project
3. Discounts ALL cash flows properly

66
The Internal Rate of Return

The IRR (internal rate of return) of a project is defined as the rate-of-return-like

number which sets the NPV equal to zero.

C1 C2 C3
0  C0    
(1  IRR ) (1  IRR ) (1  IRR )
2 3

In the context of bonds, the IRR boils down to the Yield-To-Maturity (YTM).

Example: C0 = −$10, C1 =+$5, C2 =+$8.

Solve:
$5 $8
 $10  
1  IRR (1  IRR) 2
0  IRR  18%
Potential rule: Accept (reject) investment opportunities where IRR exceeds (is
less than) the opportunity cost of capital.
This is subject to numerous pitfalls!

67
The Concept of IRR

• The IRR is not a rate of return in the sense that it is not a return
offered by equivalent-risk investments in the capital market.

• IRR is a “characteristic” of a project cash flows. It is purely a

mapping from, a “summary statistic” of, many cash flows into
one single number.

• Intuitively, you can consider “internal rate of return” of a project

to be sort of a “time-weighted average rate of return intrinsic to
cash flows”.

• Note: Multiplying each and every cash flow by the same factor,
positive or negative, will not change the IRR.

68
Finding the IRR

• There is no general algebraic formula for projects with

many cash flows:
– The solution is a polynomial root.
– With too many cash flows, its order is too high.

• Iterate to find the solution:

– Manually: intelligent trial-and-error.
– Computer-accomplished: Excel (“IRR” or Solver),
OpenOffice, Financial Calculators.

69
The difference between IRR and the cost of capital is the
maximum amount of estimation error in the cost of capital
you can “afford” w/o altering the original decision.
70
Obscure Problems?

• You are guaranteed one unique IRR if you have a first, up-front
cash flow that is an investment (a single negative number), followed
only by positive cash flows (payback). (The same is the case in the
reverse.)

– Such a cash flow pattern is the case for financial bonds.

Thus, the YTM for a bond is usually unique.

– This cash flow pattern is also usually the case for most
normal corporate investment projects.

– In the real world, there are very few projects that have both
positive and negative cash flows that alternate many times.

71
Pitfall 1: Lend or Borrow?

Project C0,$ C1,$ IRR,% NPV at 10%

A -100 +150 50 +36.4
B +100 -150 50 -36.4

• Even though both projects have IRR of 50%, they are not
equally attractive!
• Project A: invest and get 50%, better than any bank account!
• Project B: receive $100 to repay $150 later – borrowing at 50%,
bad deal!
• Can’t say whether 50% IRR is good or bad, unless know type of
the project: want high rate on lending money and low rate on
borrowing money.

72
IRR as a Capital Budgeting Rule

• Because you cannot do any better than doing right, always using NPV is the
best.
• The nice thing is that the rule
Invest if “IRR project” > “cost of capital (IRR elsewhere)”
where the cost of capital is your prevailing interest rate, often (but not always)
leads to the same answer as the NPV rule, and thus the correct answer. This is also
the reason why IRR has survived as a common method for “capital budgeting.”
• This applies to “projects” that are “first money out, then money in.”

• If you use IRR correctly and in the right circumstances, it can not only give you
the right answer, it can also often give you nice extra intuition.

• Watch out for the sign:

Borrow if “IRR of capital” < “IRR elsewhere”
• This applies to “projects” that are “first money in, then money out.”

73
Pitfall 2: Multiple IRRs

There are two IRRs for this project:

$200 $800

0 1 2 3
-$200 - $800
NPV

$100.00
100% = IRR2
$50.00

$0.00
-50% 0% 50% 100% 150% 200%
($50.00)
0% = IRR1 Discount rate
($100.00)

($150.00)
74
Pitfall 3: Mutually exclusive projects and Scale

• Would you rather make 100% or 50% on your

investments?
• What if the 100% return is on a $1 investment while the
50% return is on a $1,000 investment?
• Do you want a high percentage return, or do you want to
be rich?

• IRR doesn’t change with scale of the project, while NPV

does.
75
Pitfall 4: Mutually exclusive projects and Timing

$10,000 $1,000 $1,000

Project A
0 1 2 3
-$10,000
$1,000 $1,000 $12,000
Project B
0 1 2 3
-$10,000
The preferred project in this case depends on the discount rate,
not the IRR.
76
The Timing Problem

$5,000.00
$4,000.00
Project A
$3,000.00
Project B
$2,000.00
10.55% = crossover rate
$1,000.00
NPV

$0.00
($1,000.00) 0% 10% 20% 30% 40%

($2,000.00)
($3,000.00)
12.94% = IRRB 16.04% = IRRA
($4,000.00)

Discount rate

77
IRR

Disadvantages:
1. There may be no IRR (i.e. no real root of the polynomial).
2. There may be multiple IRR’s.
3. IRR is scale insensitive (which can cause problems comparing projects).
4. The benchmark cost of capital may be time-varying, in which case the IRR
may not be easily comparable.

Advantages:
• Easy to understand and communicate
• Your cost of capital does not enter into the IRR calculation.
Thus, IRR has the advantage that you do not need to recalculate the whole
project value under different cost-of-capital scenarios (if you want to play
around with projects before talking to the bank).
But that is so easy to do anyway – just graph your NPV(r)!

78
The Profitability Index (PI) Rule
NPV
• Minimum Acceptance Criteria: PI 
– Accept if PI > 0 Initial Investment
• Same answer as NPV when Initial Investment is an outflow.
• Generally cannot be used for mutually exclusive projects (shares
same problems with IRR: scale and timing).
• Does not have the advantage of IRR of keeping the cost of
capital separate.

• BUT: Is useful when available investment funds are limited!

– Projects can be ranked according to PI.
• Also easy to understand and communicate

79
PI Rule and capital rationing

• Soft rationing: not imposed by investors.

E.g. upper management may impose a limit on the amount
junior managers can spend.
• Hard rationing: firm actually can’t raise money it needs.
Need to select the package of projects with highest
“bang for the buck” (or bang per constrained resource unit).
Project NPV Fraction of Warehouse Profitability Index
($mln) Required (%)
A 100 100 1
B 75 60 1.25
C 75 40 1.875
Take B and C

80
PI Rule and capital rationing

• Suppose now B only takes 50%, but there is another project D

with a low profitability index.
Project NPV Fraction of Warehouse Profitability Index
($mln) Required (%)
A 100 100 1
B 75 50 1.5
C 75 40 1.875
D 5 10 0.5
Take D as well even though it is ranked last in terms of PI.
• Ranking by PI works well as long as you fully satiate the
constraint. Otherwise: be careful!
• In general can use linear and integer programming to optimize
total NPV subject to the constraint(s) (especially with multiple
resource constraints).
81
Question for Self-Assessment

Write down the general constrained maximization problem which

you can solve to select the optimal combination of projects to be
undertaken.
a) if they are not scalable (i.e. you either take it or not)
b) if they are arbitrarily scalable

82
The Payback Period Rule

• How long does it take the project to “pay back” its initial
investment?

• Payback Period = number of years to recover initial costs

• Minimum Acceptance Criteria:

– set by management

• Ranking Criteria:
– set by management: e.g. select shortest payback

Project C0 C1 C2 Payback
A -1 +2 1
B -1 +200 2

83
The Payback Period Rule

• Disadvantages:
– Ignores the time value of money
– Ignores cash flows after the payback period
– Biased against long-term projects
– Requires an arbitrary acceptance criteria
– A project accepted based on the payback criteria may not
have a positive NPV

• Advantages:
– Easy to understand
– May be useful if managers cannot be trusted to provide good
estimates of far out future cash flows.

84
Discounted Payback Period Rule
• How long does it take the project to “pay back” its initial
investment taking the time value of money into account?

• Will never accept a negative-NPV project (with positive cash

flows in the future).

• By the time you have discounted the cash flows, you might as
well calculate the NPV.

• If a project has a long DPP, then managers may use it as a

warning signal: check that proposer is not too optimistic (e.g.
competitors do not enter and eat into project cash flows).

85
Average Accounting Return Rule
• Another attractive but fatally flawed approach.
Average Net Income
AAR 
Average Book Value of Investment
• Ranking Criteria and Minimum Acceptance Criteria set by
management
• Disadvantages:
– Ignores the time value of money
– Uses an arbitrary benchmark cutoff rate
– Based on book values, not cash flows and market values
• Advantages:
– The accounting information is usually available
– Easy to calculate

86
Summary

• Some of the most popular alternatives to NPV:

– Internal rate of return
– Profitability index
– (Discounted) Payback period
– Accounting rate of return

• When it is all said and done, they are not the NPV rule; for those
of us in finance, it makes them decidedly second-rate.

87
The Equivalent Annual Cost Method
• There are times when a blind application of the NPV rule can
lead to the wrong decision (but the correct application will of
course give the correct answer!)

• Consider a factory which must have an air cleaner. The

equipment is mandated by law, so there is no “doing without”.
• There are two choices:
– The “Cadillac cleaner” costs $4,000 today, has annual
operating costs of $100 and lasts for 10 years.
– The “cheaper cleaner” costs $1,000 today, has annual
operating costs of $500 and lasts for 5 years.
• Which one should we choose?

88
The Equivalent Annual Cost Method
At first glance, the cheap cleaner has the lower NPV (r =
10%):

10
$100
NPVCadillac  $4,000   t
 4,614.46
t 1 (1.10)

5
$500
NPVcheap  $1,000   t
 2,895.39
t 1 (1.10)

This overlooks the fact that the Cadillac cleaner lasts twice
as long.
When we incorporate that, the Cadillac cleaner is actually
cheaper.
89
The Equivalent Annual Cost Method
The Cadillac cleaner time line of cash flows:

-$4,000 –100 -100 -100 -100 -100 -100 -100 -100 -100 -100

0 1 2 3 4 5 6 7 8 9 10
10
$100
NPVCadillac  $4,000   t
 4,614.46
t 1 (1.10)

The “cheaper cleaner” time line of cash flows over ten years:

-$1,000 –500 -500 -500 -500 -1,500 -500 -500 -500 -500 -500

0 1 2 3 4 5 6 7 8 9 10
5
$500 $1,000 10 $500
NPVcheap  $1,000   t
 5
 t
 $4,693.20
t 1 (1.10) (1.10) t 6 (1.10)
90
Investments of Unequal Lives

• Matters when projects can/must/will be repeated.

• Replacement Chain method

– Repeat the projects forever, find the PV of that perpetuity.

• Matching Cycle method

– Repeat projects until they begin and end at the same time –
like we just did with the air cleaners.
– Compute NPV for the “repeated projects”.

• The Equivalent Annual Cost method

(also called equivalent annual annuity)

91
Investments of Unequal Lives: EAC
• The Equivalent Annual Cost Method
– Applicable to a much more robust set of circumstances than
replacement chain or matching cycle.
– The Equivalent Annual Cost is the value of the level payment
annuity that has the same PV as our original set of cash flows.
– NPV = EAC × ArT
– For example, the EAC for the Cadillac air cleaner is $750.98

10 10
$100 $750.98
 $4,000   t
 4,614.46   t
t 1 (1.10) t 1 (1.10)

The EAC for the cheaper air cleaner is $763.80 which

confirms our earlier decision to reject it.
92
Replacement problem
• What if you already own a cleaner that has $700 operating costs
and will last for 2 more years before it has to be replaced.

• Would you replace it now, in a year or in two years?

93