Appendix 7A

Difficulties in Solving for

an Interest Rate

Copyright Oxford University Press 2014

 Chapter Outline

• Why Multiple Solutions can Occur?

• Modified Internal Rate of Return (MIRR)
Calculation
• Solving MIRR using Spreadsheets

Copyright Oxford University Press 2014

 Learning Objectives

• Understand why multiple solutions can

occur
• Identify when multiple roots can occur
• Develop and use spreadsheet in solving
MIRR

Copyright Oxford University Press 2014

 Example 7A-1
Cash Flow with Multiple Solutions
A piece of land may be purchased for $610,000 to be strip-
mined for the underlying coal. Annual net income will be
$200,000 for 10 years. At the end of 10 years, the surface of
the land will be restored as required by a federal law on strip
mining. The reclamation will cost $1.5 million more than the
land’s resale value after it is restored. Is this a desirable
project, if the minimum attractive rate of return is 10%?

200k 200k

0 1 2 3 4 5 6 7 8 9 10

1500k
610k

Copyright Oxford University Press 2014

 Example 7A-1
Cash Flow with Multiple Solutions
Yr Cash Flow NPV
0 −$610k $60,00
1 +200k $40,00
2 +200k
$20,00
3 +200k
4 +200k $-
5 +200k $(20,00) 0% 5% 10% 15% 20% 25% 30%
6 +200k $(40,00)
7 +200k $(60,00)
8 +200k
$(80,00)
9 +200k
+200k − $(100,00)
10 1500K $(120,00)

Copyright Oxford University Press 2014

 Example 7A-1
Cash Flow with Multiple Solutions
• Example 7A–1 demonstrates that cash flows can have
multiple solutions to the IRR equation (PW=0).
• The example also demonstrates a common feature of
such a problem—the cash flows fit neither the pattern
of an investment nor the pattern of a loan.
• Example 7A–1 has two sign changes in its series of
cash flows. Two or more sign changes in the series of
cash flows are the distinguishing feature of instances
where multiple roots can, but may not, arise when
solving for the rate of return for a set of cash flows.

Copyright Oxford University Press 2014

 Multiple IRR
Occurs when a cash flow produces more than one point at
which NPW = 0. This happens when there is more than
one sign change in the cash flow series
Example 7A-1
Cash Flow
Year Cash Flow
80
0 19
60
1 10 40
2 -50 20
3 -50 0
4 20 -20 1 2 3 4 5 6
-40
5 60 -60

7
EGR 403 - Cal Poly Pomona - SA10
 Example 7A-1

This series of cash flows produces two

solutions for IRR: 10.2% and 47.3%.

8
EGR 403 - Cal Poly Pomona - SA10
 Cash Flow Rule of Signs

• May be converted to a polynomial

• Then, by Descartes’ rule
Number of sign Number of positive values
changes, m of X

0 0
1 1
2 2 or 0
3 3 or 1

4 4, 2 or 0

Engineering
9
Economic
 Cash Flow Rule of Signs
Expands on This Notion
• There may be as many positive values of
“i” as there are sign changes in the cash
flow.
• Sign changes are counted when:
– + to -
– - to +
• A zero cash flow is ignored

Engineering
10
Economic
 Cash Flow Rule of Signs
- Possibilities -

Number of sign changes, m Number of positive values of “i”

0
0
1
1 or 0
2
2, 1 or 0
3
3, 2, 1 or 0
4
4, 3, 2, 1 or 0
Engineering
11
Economic
 Zero Sign Changes

• Receiving a gift
• Giving your friend a loan and not being
paid back

In either case, no “i” can be computed.

Engineering
12
Economic
 What to do if cash flow has two or
more sign changes?
• Traditional approach tends to focus attention on
hypothetical possibilities.
• A simpler approach is to graph present worth values over
an appropriate range of negative and positive interest rates.
• In general, the range (−100%, 100%] includes the interest
rates and present worth values that are useful for decision
making.
• When multiple roots occur, there is usually a negative root
that can be ignored and a positive root that can be used.
• If there is only one root and it is negative, then it is a valid
IRR.

Copyright Oxford University Press 2011

 Projects with
Multiple Sign Changes
• The most common case of two or more sign changes
in cash flows is projects with a salvage cost which
typically have two sign changes.
• This salvage cost can be large for environmental
restoration at termination.

Copyright Oxford University Press 2014

 Example 7A-2
Cash Flow with Multiple Solutions
This project is representative of ones with a salvage cost.
How many roots for the PW equation exist?

50k

0 1 2 3 4 5 6 7

70k
180k

Copyright Oxford University Press 2014

 Example 7A-2
Cash Flow with Multiple Solutions
Yr Cash Flow NPV
$250,00
0 −$180k
$200,00
1 +50k
$150,00
2 +50k
3 +50k $100,00

4 +50k $50,00

5 +50k $-
-50% -40% -30% -20% -10% 0% 10% 20% 30% 40% 50%
6 +50k $(50,00)
7 −$70k
$(100,00)

$(150,00)

• In this case, there is one positive root of 10.45%. The value can be
used as an IRR.
• There is also a negative root of −38.29%. This root is not useful.
Copyright Oxford University Press 2014
 Example 7A-3
Cash Flow with Multiple Solutions
Adding an oil well to an existing field costs $4M. It will increase
recovered oil by $3.5M, and it shifts $4.5M worth of production
from Years 5, 6, and 7 to earlier years. Thus, the cash flows
for Years 1 through 4 total $8M and Years 5 through 7 total
−$4.5M. If the well is justified, one reason is that the oil is
recovered sooner. How many roots for the PW equation exist?
Is one useful as an IRR, and should the project be funded?
3.5M
2.5M
1.5M 0.5M

0 1 2 3 4 5 6 7

-0.5M
-1.5M
4M
-2.5M

Copyright Oxford University Press 2014

 Example 7A-3
Cash Flow with Multiple Solutions
Yr Cash Flow NPV
0 −$4M $0,50

$0,40
1 +3.5M $0,30
2 +2.5M $0,20

3 +1.5M $0,10

4 +0.5M $-
0% 10% 20% 30% 40% 50% 60%
5 −0.5M $(0,10)

$(0,20)
6 −1.5M
$(0,30)
7 −2.5M $(0,40)

$(0,50)

$(0,60)

• In this case, there are positive roots at 4.73 and 37.20%. These
roots are not useful.

Copyright Oxford University Press 2014

 Modified Internal Rate of Return
(MIRR)
• The MIRR is a measure of the attractiveness of the
cash flows, but it is also a function of the two external
rates of return.
– External rates for investing, 𝑒𝑖𝑛𝑣
– External rate for financing, 𝑒fi𝑛
• The rate for investing is generally higher than the rate
for financing.

Copyright Oxford University Press 2014

 Modified Internal Rate of Return
(MIRR)
1. Combine cash flows in each period (𝑡) into a single net
receipt, 𝑅𝑡, or net expense, 𝐸𝑡.
2. Find the present worth of the expenses with the
financing rate.
3. Find the future worth of the receipts with the investing
rate.
4. Find the MIRR which makes the present worth and
future worth equivalent.

𝐹 Τ𝑃 , 𝑀𝐼𝑅𝑅, 𝑛 ෍ 𝐸𝑡 𝑃Τ𝐹 , 𝑒𝑓𝑖𝑛 , 𝑡 = ෍ 𝑅𝑡 𝐹 Τ𝑃 , 𝑒𝑖𝑛𝑣 , 𝑛 − 𝑡

𝑡 𝑡

Copyright Oxford University Press 2014

 Example 7A-5 MIRR
(7A-3 Revisited)

3.5M
2.5M
1.5M 0.5M

0 1 2 3 4 5 6 7

-0.5M
-1.5M
4M
-2.5M

F
0 1 2 3 4 5 6 7

Copyright Oxford University Press 2014

 Example 7A-5 MIRR

0.5M(F/P, 15%,3)+
1.5M(F/P, 15%,4)+
3.5M
2.5M 2.5M(F/P,15%,5)+
1.5M 3.5M(F/P,15%,6)
0.5M =FW(Rt)
0 1 2 3 4 5 6 7 0 1 2 3 4 5 6 7
0.5M
1.5M 4M +
2.5M
0.5M(P/F, 8%, 5) +
4M 1.5M(P/F, 8%, 6) +
2.5M(P/F, 8%, 7)=PW(Et)

PW(Et)=6.744M; FW(Rt)=16.507M; MIRR=13.64%

Copyright Oxford University Press 2014
 Spreadsheet and MIRR

Excel Functions Purpose

MIRR(values, finance_rate, reinvest_rate)
To find Modified internal
rate of return (MIRR) of a
series of cash flow (period
0 to n) using finance_rate
for negative cash flows, and
reinvest_rate for positive
cash flows.

Copyright Oxford University Press 2014