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Ch10 Tool Kit NPV dan IRR

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Ch10 Tool Kit NPV dan IRR

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12 In this file we use Excel to do most of the calculations explained in the textbook. First, we analyze

13 Projects S and L, whose cash flows are shown immediately below in time line formats. Spreadsheet

14 analyses can be set up vertically, in a table with columns, or horizontally, using time lines. For short

15 problems, with just a few years, we generally use the time line format because rows can be added and we

16 can set the problem up as a series of income statements. For long problems, it is often more convenient to

17 use a vertical layout.

18

19

20

21 Figure 10-1. Net Cash Flows (CFt) and Selected Evaluation Criteria for Projects S and L

22

23 Panel A: Project Cash Flows and Cost of Capital

24

25 Project cost of capital, r, for each project: 10%

26

27 Initial Cost After-Tax, End of Year, Project Cash Flows, CFt

28 0 1 2 3 4

29 Project S -$10,000 $5,000 $4,000 $3,000 $1,000

30 Project L -$10,000 $1,000 $3,000 $4,000 $6,750

31

32 Panel B: Summary of Selected Evaluation Criteria $6,750

33

34 Project S Project L

35 NPV $788.20 $1,004.03

36 IRR 14.49% 13.55%

37 MIRR 12.11% 12.66%

38 PI 1.08 1.10

39 Payback 3.30

40 Discounted Payback 2.95 3.78

41

42

43

44

45

46 Figure 10-2. Finding the NPV for Projects S and L

47

48 To calculate the NPV, we find the present value of the individual cash flows and then sum those

49 discounted cash flows. The sum is the value the project adds to or subtracts from shareholder wealth.

50

51 r = 10%

52

53 Year = 0 (r = 10%) 1 2 3 4

54 Project S -10,000.00 5,000 4,000 3,000 1,000

A B C D E F G

55 4,545.45

56 3,305.79

57 2,253.94

58 683.01

59 NPVS = $788.20 Long way: Sum the PVs of the CFs to find NPV

60

61 Year = 0 (r = 10%) 1 2 3 4

62 Project L -10,000.00 1,000 3,000 4,000 6,750

63

64 NPVL = $1,004.03 Short way: Use Excel's NPV function =NPV(B51,C62:F62)+B62

65

66

67

68

The NPV criterion says that all independent projects that have positive NPV should accepted. The

rationale for this is that all such projects add wealth, and that should be the overall goal of the manager in

69

all respects. If strictly using the NPV method to evaluate two mutually exclusive projects, you would want

70

to accept the project that adds the most value (i.e. the project with the higher positive NPV). Hence, if

71

considering the above two projects, you would accept both projects if they are independent, and you

72 would only accept Project L if they are mutually exclusive.

73

74

75 INTERNAL RATE OF RETURN (IRR) (Section 10.3)

76

77

78 The internal rate of return is defined as the discount rate that equates the present value of a project's cash

79 inflows to its outflows. In other words, the internal rate of return is the interest rate that forces NPV to

80 zero. The calculation for IRR can be tedious, but Excel provides an IRR function that merely requires

81 you to access the function and enter the array of cash flows. The IRRs for Project S and L are shown

below, along with the data entry for Project S.

82

83

84

85

86 Figure 10-3. Finding the IRR

87

88 r = 14.49%

89 Year = 0 1 2 3 4

90 Project S -10,000.00 5,000 4,000 3,000 1,000

91 4,367.24

92 3,051.64

93 1,999.09

94 582.03

A B C D E F G

95 Sum of PVs = $0.00 = NPV at r = 14.489%. NPV = 0, so IRR = 14.489%.

96

97 IRRS = 14.49% =IRR(B90:F90) using IRR function

98

99 Year = 0 1 2 3 4

100 Project L -10,000.00 1,000 3,000 4,000 6,750

101

102 IRRL = 13.55% =IRR(B100:F100) using IRR function

103

104

105

106 The IRR method of capital budgeting maintains that projects should be accepted if their IRR is greater

107 than the cost of capital. Strict adherence to the IRR method would further dictate that mutually exclusive

108

projects should be chosen on the basis of the greater IRR. In our example, each project has an IRR that

exceeds the cost of capital (10%) so both projects should be accepted if they are independent. If, however,

109 the projects are mutually exclusive, we would choose Project S because it has the higher IRR. Recall that

this differs from our conclusion when using the NPV method. So, we have a conflict between the NPV

110 and the IRR methods for ranking Projects S and L.

111

112

113 MULTIPLE IRRS (Section 10.4)

114

A B C D E F G

115 Because of the mathematics involved, it is possible for some (but not all) projects that have more than one

116 change of signs in the cash flows to have more than one IRR. If you attempted to find the IRR with such

117 a project using a financial calculator, you would get an error message. The HP-10B says "Error - Soln",

118 the HP-17B says '"Many/No Solutions, and the HP12C says Error 3; Key in Guess." The procedure for

119 correcting the problem is to store in a guess for the IRR, and then the calculator will report the IRR that

120 is closest to your guess. You can then use a different "guess" value, and you should be able to find the

other IRR. However, the nature of the mathematics creates a scenario in which one IRR is quite

121 extraordinary (often, several hundred percent).

122

123

124 Figure 10-4. Graph for Multiple IRRs: Project M (Millions of Dollars)

125

126

127 Year = 0 1 2

128 Project M -1.60 10 -10

129

130 r = 10% NPV = -$0.774

131

132 NPV

133 (Millions)

134

135 $0.90

NPV = −$1.6 + $10/(1+r) + (−$10)/(1+r)2

136

137 $0.70

138

139

$0.50

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142 $0.30

143 IRR #1 = 25% IRR #2 = 400%

144

$0.10

145

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147 -$0.10 0% 50% 100% 150% 200% 250% 300% 350% 400% 450% 500%

148

149

-$0.30

150

Cost of Capital (%)

151

152

153 Note:

154 The table shown below calculates Project M's NPV at the rates shown in the left column. These data are plotted to

155 form the graph shown above. Notice that NPV = 0 at both 25% and 400%. Since the definition of the IRR is the

156 rate at which the NPV = 0, there are two IRRs.

157

158 r NPV

A B C D E F G

159

160 0% -$1.600

161 10% -$0.774

162 25% $0.000 = IRR #1 = 25%

163 110% $0.894

164 400% $0.000 = IRR #2 = 400%

165 500% -$0.211

166

167

168

169 REINVESTMENT RATE ASSUMPTIONS (Section 10.5)

170

171

172 The IRR approach assumes that cash flows can be reinvested at the IRR, but it is more realistic to asssume that

cash flows only can be reinvested at the cost of capital. For this reason, NPV is a better decision criterion than IRR.

173

174

175 MODIFIED INTERNAL RATE OF RETURN, MIRR (Section 10.6)

176

177 The modified internal rate of return is the discount rate that causes a project's cost (or cash outflows) to equal the

178 present value of the project's terminal value. The terminal value is defined as the sum of the future values of the

179 project's cash inflows, compounded at the project's cost of capital. To find MIRR, calculate the PV of the outflows

180 and the FV of the inflows, and then find the rate that equates the two. Alternatively, you can solve using Excel's

181 MIRR function.

182

183 One advantage of using the MIRR, relative to the IRR, is that the MIRR assumes that cash flows received are

184 reinvested at the cost of capital, not the IRR. Since reinvestment at the cost of capital is more likely, the MIRR is a

185 better indicator of a project's profitability. Moreover, it solves the multiple IRR problem, as a set of cash flows can

186 have but one MIRR.

187

188 Also, note that Excel's MIRR function allows for discounting and reinvestment to occur at different rates.

189 Generally, MIRR is defined as reinvestment at the WACC, though Excel allows the calculation of MIRR where

190 reinvestment is likely to occur at a different rate than WACC.

191

192 As is stated in the text, NPV is superior to the IRR because (1) the NPV assumes that cash flows are reinvested at

193 the cost of capital whereas the IRR assumes reinvestment at the IRR, and (2) it is more likely, in a competitive

194 world, that the actual reinvestment rate will be the cost of capital than the IRR, especially if the IRR is quite high.

195 The MIRR setup can be used to prove that NPV indeed does assume reinvestment at the WACC and IRR at the

196 IRR.

197

198 If negative cash flows occur in years beyond Year 1, those cash flows should be discounted at the cost of capital and

199 added to the Year 0 cost to find the total PV of costs. If both positive and negative flows occurred in a given year,

200 the negative flows should be discounted, and the positive ones compounded, rather than just dealing with the net

201 cash flow. This can make a difference.

A B C D E F G

202

203

204 Figure 10-5. Finding the MIRR for Projects S and L

205

206 r= 10%

207

208 Year = 0 (r = 10%) 1 2 3 4

209 Project S -10,000 5,000 4,000 3,000 1,000

210 $3,300

211 $4,840

212 $6,655

213 -10,000 Terminal Value (TV) = $15,795

214

215 Calculator: N = 4, PV = -10000, PMT = 0, FV = 15795. Press I/YR to get: MIRRS = 12.11%

216 Excel Rate function--Easier: =RATE(F208,0,B209,F213) MIRRS = 12.11%

217 Excel MIRR function--Easiest: =MIRR(B209:F209,B206,B206) MIRRS = 12.11%

218

219 Year = 0 (r = 10%) 1 2 3 4

220 Project L -10,000 1,000 3,000 4,000 6,750

221

222 For Project L, using the MIRR function: =MIRR(B220:F220,B206,B206) = MIRRL = 12.66%

223

224 Notes:

225 1. In Figure 10-5 we find the discount rate that forces the present value of the terminal

226 value to equal the project's cost. That discount rate is defined as the MIRR.

227 $10,000 =TV/(1+MIRR)N = $15,795/(1+MIRR)4 . We can find the MIRR with a

228 calculator or Excel.

229 2. If S and L are independent, both should be accepted as both MIRRs exceed the cost of capital. If

230 they are mutually exclusive, then L should be chosen because it has the higher MIRR.

231

232

233

234 NPV PROFILES (Section 10.7)

235

236 An NPV profile shows how a project's NPV declines as the WACC used to calculate the NPV increases. Figure 10-

237 4, for the multiple IRR example, shows a NPV profile. Normally, though, the cash flows change sign only once--a

238 negative for the Time = 0 cash flow and then positive cash flows thereafter, so normally NPV profiles look like the

239 one in Figure 10-6.

240

241

242 Figure 10-6. NPV Profile for Project S

243

244 Cost of capital = 10.00%

245 Year = 0 1 2 3 4

A B C D E F G

246 Project S -10,000.00 5,000 4,000 3,000 1,000

247

248 r NPVS

249 0% $3,000.00

250 5% 1,804.24

251 10% 788.20

252 14.489% 0.00 NPV = $0, so IRR = 14.489%

253 15% -83.30

254 20% -837.19

255

256

257 Net Present Value for S PROJECT S's NPV PROFILE

258

259

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263 $2,000 NPVS = 0, so IRR = 14.489%

264

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271

272

273 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%

274

275 Cost of Capital (%)

276 -$1,000

277

278

279

280

281

282 The Crossover Rate

283

284 The crossover rate is the rate at which the NPV of Project S is equal to the NPV of Project L. The easiest way to

285 find the crossover rate is to subtract one project's cash flows from the others and find the IRR of this differential

286 cash flow stream.

287

288

289 Year = 0 1 2 3 4

290 Project S -$10,000 $5,000 $4,000 $3,000 $1,000

291 Project L -10,000 1,000 3,000 4,000 6,750

292 D = CFS − CFL $0 $4,000 $1,000 -$1,000 -$5,750

A B C D E F G

293

294 IRR D = 11.975%

295

296

A B C D E F G

297 Figure 10-7. NPV Profiles for Projects S and L: Shows Why Conflict Occurs

298

299 Cost of Capital NPVS NPVL

300 0% $3,000.00 $4,750.00

301 5% 1,804.24 2,682.06

302 10% 788.20 1,004.03

303 Crossover = 11.975% 428.38 428.38 NPVS = NPVL

304 IRRL = 13.549% 156.40 0.00 NPVL = 0

305 IRRS = 14.489% 0.00 -243.65 NPVS = 0

306 20% -$837.19 -$1,513.31

307

308 $5,000 NPV

309

310 L

311

Crossover: Conflict if WACC is to

312

$4,000 left of crossover, no conflict if

313 WACC is to right. Since WACC =

314 10%, which is left of the crossover

315 rate, there IS a conflict: NPVL >

316 S NPVS, but IRRS > IRRL.

$3,000

317

318 At WACC:

319 NPV L > NPVS

320

$2,000

321

322

323

324

$1,000

325

326 IRRS > IRRL

327 NPVS at WACC

328

$0

329

0% 10% 20% Cost of Capital 30%

330

331

332 IRRL

333 -$1,000

334

335

336

337 -$2,000

338

339

340

341

342 PROFITABILITY INDEX (PI) (Section 10.8)

343

344 The profitability index is the present value of all future cash flows divided by the intial cost. It measures the PV

per dollar of investment.

A B C D E F G

345 per dollar of investment.

346

347

348

349 Figure 10-8. Profitability Index (PI)

350

351 Project S: PIS = PV of future cash flows ÷ Initial cost

352 PIS = $10,788.20 ÷ $10,000

353 PIS = 1.0788

354

355 Project L: PIL = PV of future cash flows ÷ Initial cost

356 PIL = $11,004.03 ÷ $10,000

357 PIL = 1.1004

358 Notes:

359 1. If Projects L and S are independent, both should be accepted as both have PI greater than 1.0.

360 However, if they are mutually exclusive, Project L should be chosen as it has the higher PI.

361 2. PI and NPV rankings will be consistent if the projects have the same cost, as is true for S and L.

362 However, if they differ in size, conflicts can occur. In the event of a conflict, the NPV ranking

363 should be used.

364

365

366 PAYBACK PERIOD (Section 10.9)

367

368

369 The payback period is defined as the expected number of years required to recover the investment, and it was the

370 first formal method used to evaluate capital budgeting projects. First, we identify the year in which the cumulative

cash inflows exceed the initial cash outflows. That is the payback year. Then we take the previous year and add to

371

it the unrecovered balance at the end of that year divided by the following year's cash flow. Generally speaking,

372 the shorter the payback period, the better the investment.

373

374

375

It's easy to calculate the payback manually--calculate cumulative cash flows and look to see when the cumulative

376 CF turns positive, and recognize that the payback year is the prior year plus a fraction equal to the shortfall

377 divided by the CF in the next year. However, it would be useful to have an automated procedure if you were

378 calculating many paybacks or if you wanted to do sensitivity analysis for a given project, but this is more

379 complicated. You can see the formula below, and the procedure is explained in detail in our Excel Tutorial. We use

380 the formula only if we must do a number of payback calculations--for just one or two, the manual approach is

much easier.

381

382

383

A B C D E F G

384 Figure 10-9. Payback Period

385

386 Years = 0 1 2 3 4

387 Project S Cash flow -10,000 5,000 4,000 3,000 1,000

388 Cumulative cash flow -10,000 -5,000 -1,000 2,000 3,000

389 Intermediate calculation for payback - - - 2.33 5.00

390

391 Intermediate calculation:

392 Manual calculation of Payback S = 2 + $1,000/$3,000 = 2.33 =IF(F388>0,E386+ABS(E388/F387),"-")

393 Excel calculation of Payback S = 2.33 2.33

394

395 Years 0 1 2 3 4

396 Project L Cash flow -10,000 1,000 3,000 4,000 6,750

397 Cumulative cash flow -10,000 -9,000 -6,000 -2,000 4,750

398

399 Manual calculation of Payback L = 3 + $2,000/$6,750 = 3.30 Payback is between

400 Alternative Excel calculation of Payback L = negative and positive

cumulative cash flow.

401 =PERCENTRANK(C397:G397,0,6)*G395 = 3.30

402

403

404

405

406

The regular payback has two major flaws. First, it does not take account of any cash flows that occur past the

payback year, no matter how large those flows might be. Second, the payback does not take account of the time

407

value of money. This second problem is addressed with the discounted payback as discussed below, but the failure

408

to consider beyond-payback cash flows is a problem for both payback methods.

409

410

411

412 Figure 10-10. Discounted Payback

413

414 WACC = 10%

415 Years = 0 1 2 3 4

416 Project S Cash flow -10,000.00 5,000.00 4,000.00 3,000.00 1,000.00

417 Discounted cash flow -10,000.00 4,545.45 3,305.79 2,253.94 683.01

418 Cumulative discounted CF -10,000.00 -5,454.55 -2,148.76 105.18 788.20

419

420 Discounted Payback S = 2 + $2,148.76/$2,253.94 = 2.95 Payback is between

421 Excel calculation of Discounted Payback S = negative and positive

422 =PERCENTRANK(C418:G418,0,6)*G415 = 2.95 cumulative discounted cash

423 flow.

424 Years 0 1 2 3 4

425 Project L Cash flow -10,000.00 1,000.00 3,000.00 4,000.00 6,750.00

426 Discounted cash flow -10,000.00 909.09 2,479.34 3,005.26 4,610.34

427 Cumulative discounted CF -10,000.00 -9,090.91 -6,611.57 -3,606.31 1,004.03

428

429 Discounted Payback L = 3 + $3,606.31/$4,610.34 = 3.78 Payback is between negative

and positive cumulative

discounted cash flow.

A B C D E Payback F G

is between negative

430 Excel calculation of Discounted Payback L = and positive cumulative

431 =PERCENTRANK(C427:G427,0,6)*G424 = 3.78 discounted cash flow.

432

433

434

435 CONCLUSIONS ON CAPITAL BUDGETING METHODS (Section 10.10)

436

437 NPV is the single best criterion because it provides a direct measure of the value a project adds to shareholder

438 wealth. However, all methods provide helpful information.

439

440

441 DECISION CRITERIA USED IN PRACTICE (Section 10.11)

442

443 NPV and IRR are the most widely used methods.

444

H

12

rst, we analyze

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ats. Spreadsheet

e lines. For

14 short

can be added

15 and we

en more convenient

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n sum those

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hareholder

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d accepted.68

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goal of the manager in

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rojects, you would want

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ve NPV). Hence, if

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pendent, and you

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value of a 78

project's cash

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79 NPV to

hat merely80requires

S and L are81 shown

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their IRR

106is greater

that mutually

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oject has108

an IRR that

ependent. If, however,

gher IRR.109Recall that

t between the NPV

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114

H

hat have 115

more than one

nd the IRR116 with such

B says "Error

117 - Soln",

" The procedure

118 for

ll report 119

the IRR that

d be able120

to find the

e IRR is quite

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These data154

are plotted to

nition of the

155IRR is the

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alistic to asssume

172 that

ision criterion than IRR.

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177to equal the

h outflows)

he future178 values of the

te the PV 179

of the outflows

an solve using

180 Excel's

181

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183

h flows received are

ore likely,184

the MIRR is a

as a set of185

cash flows can

186

187

different188

rates.

tion of MIRR

189 where

190

191

flows are 192

reinvested at

193

ely, in a competitive

if the IRR194 is quite high.

WACC and195 IRR at the

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198

at the cost of capital and

ccurred in199 a given year,

st dealing200with the net

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capital. If229

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236 Figure 10-

PV increases.

hange sign237only once--a

PV profiles238

look like the

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284 way to

L. The easiest

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IRR of this differential

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t. It measures

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han 1.0. 359

PI. 360

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vestment,369and it was the

r in which370the cumulative

previous year and add to

371

. Generally speaking,

372

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375

see when the cumulative

ual to the 376

shortfall

377 were

cedure if you

ut this is 378

more

r Excel Tutorial.

379 We use

manual approach

380 is

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s that occur

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past the

ke account of the time

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ed below, but the failure

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tween negative

e cumulative

d cash flow.

tween negative H

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e cumulative

d cash flow.431

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adds to shareholder

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