LECTURE – 14 (Discounted Cash Flows Techniques (Part 2))

I said at the end of the last lecture where we worked out the NPV for example
one to keep hold of your figures because here we are going to do something else
from it

I would like you to have a look at the next bit of the notes it talks about
the internal rate of return

Now I have already discussed the internal rate of return when we looked at the
chapter on cost of debt and to be honest it is very unlikely that you will be asked
to work out the internal rate of return for a project in this exam but I need
to check it with you because there is something new that can be asked it is called
the 'Modified Internal Rate of Return'

Before I explain to you what that is let's discuss example two first which says

EXAMPLE – 2
Calculate the internal rate of return for the project in Example – 1

Solution -
Statement on discounting the cash flows of Rome plc (At 10%)
(Amount is '000)
Particulars Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
Net cash flows -2,000 413 411 417 431 1,508
Disc @ 10% 1.000 0.909 0.826 0.751 0.683 0.621
Present value -2,000 375 339 313 294 936

NPV @ 10% = $257,000

Given that the NPV is positive at 10% to get NPV = 0 the rate of interest must be
higher let us discount at a higher rate of 18% (you can use any rate you like)

Statement on discounting the cash flows of Rome plc (At 18%)

(Amount is '000)
Particulars Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
Net cash flows -2,000 413 411 417 431 1,508
Disc @ 18% 1.000 0.847 0.718 0.609 0.516 0.437
Present value -2,000 350 295 254 222 659

NPV @ 18% = - $220,000

We made our two guesses and the NPV was positive at 10% and negative at 18%
In order to get NPV = 0 the internal rate of return must be between the two
and in order to find that rate we will interpolate

INTERPOLATION –

[ ]
NPV1
Internal rate of return = R1 + (R2 – R1) x
(NPV1 – NPV2)

[ ]
257
Internal rate of return = 10% + (18% – 10%) x
(257 – (-220))

Internal rate of return = 14.30% (approx.) ]

If you remember from my earlier lectures on the cost of debt internal rate of
return is the rate of interest which gives NPV = 0 and to calculate the internal
rate of return you make two guesses and then if required you interpolate

Well again I don't want to your waste time and if you are still unsure about
internal rate of return you should look back again in the lectures on the cost
of debt

Although I have already said this in my earlier lectures on cost of debt but I will
repeat two things here –
 One is that this internal rate of return is only an approximate and we cannot
do much about it because we are effectively assuming linearity (i.e. the rate of
increase in the internal rate of return is same as the rate of reduction is the
NPV) while in reality actually a curve is formed
 Second is that because we assumed linearity while in reality actually a curve
is formed so if we make different guesses we will get slightly different answers

Now I need to remind you here about the problems that we can face while using
the internal rate of return and why in this exam there is something called
the 'modified internal rate of return'

PVR 1/n
Modified internal rate of return = [[ PVI ] x (1 + RE) ]
It is very much a calculator exercise but you need to know what the symbols mean –
PVR is the present value of the return phase
PVI is the present value of the investment phase
n is the life of the project
RE is the cost of capital
Although we can work down the NPV and decide whether the project should be
accepted or rejected and we can use the internal rate of return as well in case
where -
 We know the cost of borrowing or cost of capital and we can work down the
effective rate of return from the project and if it is more than the cost of
borrowing or cost of capital we will accept while if it is less than the cost of
borrowing or cost of capital we will reject
 We are comparing two projects say Project A which gives a return of 12%
and Project B which gives a return of 15% and we know that since 15% is better
than 12% therefore we will prefer Project B

However we cannot use the internal rate of return as well in case where -
 We are comparing two projects say Project A which gives a return of 12%
for 15 years and Project B which gives a return of 15% for 5 years and
we worked out the cost of borrowing or cost of capital to be 10%
Here rationality suggest that we should prefer Project A since we will be much
happier to get slightly less per year for a longer time period as compared
to getting slightly more per year for a shorter time period

So it will be right to say that we can always compare projects by working out their
NPVs and the project which is having the higher NPV is better but we cannot
always compare projects by working out their internal rate of returns and decide
which one is better since it requires some extra information

The only time when we can compare projects by working out their internal rate of
return is in case of perpetuities and if we just think about it suppose –
 Project A gives a return of 12% for 15 years but the inflows can be re-invested
at 12% as a result we will effectively end up getting 12% forever
 Project B gives a return of 15% for 5 years but the inflows can be re-invested
at 15% as a result we will effectively end up getting 15% forever
In such case we know that since getting 15% forever is better than getting 12%
forever therefore we will prefer Project B

In order to get around this problem we have the 'Modified Internal Rate of Return'
which calculates the average return from the projects in a way which makes
it possible to compare different projects

Modified internal rate of return is different from internal rate of return since –
 IRR assumes that the receipts are re-invested at internal rate of return
 MIRR assumes that the receipts are re-invested at cost of capital
And it seems that MIRR is more logical than IRR since we cannot always have
opportunity to re-invest at IRR but we can always re-pay the amount borrowed
which usually is our cost of capital
Let's apply this in example three

EXAMPLE - 3
Calculate the modified internal rate of return for the project in Example - 1

Solution -
Outflows makes the investment phase and the inflows makes the return phase
and in Example - 1 the investment phase was only Year 0 the present value of
which was $2,000,000 and the return phase was from Year 1 to Year 5
the present value which was $2,258,000
PVR 1/n
Modified internal rate of return = [[ PVI ] x (1 + RE) ]
2258 1/5
Modified internal rate of return = [[ 2000 ] x (1 + 0.01) ]
Modified internal rate of return = 12.70% (approx.) ]
Decision –
We can accept the project since the cost of capital is 10% and we are getting
a modified rate of return of 12.70%

I have said this before that you must have a scientific calculator and that
different calculators take figures in different orders so you must make sure
you know the order for your calculator as you don't want to waste time by messing
around in the middle of the exam

Now if it ever comes to comparing two projects say Project A which gives a MIRR
of 12% and Project B which gives a MIRR of 15% and you know that since 15% is
better than 12% therefore you prefer Project B

Honestly I think modified rate of return is little bit silly and to be quite frank
I think it is a bit of cheat and it is very easy to calculate as there is a formula
and perhaps that is why it is not asked very often in the exam

All right we are getting closer I will leave this lecture here and in the next lecture
we will go straight back to discounting and as I said the example we looked at
in the last lecture was just a basic example and this exam does throw in some
extra complications and one of the very common complication is that an existing
company is setting up a new company or a subsidiary or whatever in a foreign
country where although all the basic rules remains the same but there are few
extra things to consider so in the next lecture we will go through an example on
foreign investment appraisal
SELF-NOTES
1. IRR is the rate at which the NPV = 0

2. The project under evaluation will be accepted only if the IRR exceeds the
cost of capital or the target rate of return

3. However IRR cannot be used to compare mutually exclusive projects

4. If in case there is a conflict between NPV and IRR then we can use MIRR
to theoretically decided which project is better

5. The project under evaluation will be accepted only if the MIRR exceeds the
cost of capital or the target rate of return

6. Unlike IRR which assumes that the proceeds can be re-invested at IRR
MIRR assumes that the proceeds can be re-invested at Cost of Capital

7. Multiple IRRs
Sometimes cash flows from a project tend to be negative in the later period in
such case it is has been observed that the IRR was not unique (i.e. there were
more than one IRR)

If we plot the NPVs of such project at different discount rates we will find that –
the NPV which was initially negative starts increasing became positive and reached
its maximum level and after that it starts falling became zero and then once again
became negative

6000

4000
NET PRESENT VALUE

2000

0 5% 11% 17% 23% 29% 35% 41% 47%

DISCOUNTING RATES
-2000

-4000

-6000