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Here we see seven points in time and, for each, a dollar inflow or
outflow.
At year 0 (now), the income amount is
negative. Negative income is cost, or outgo. In this example,
the negative income amount in year 0 represents the cost of buying
and installing the machine.
In the future, at years 1 through 6, there will be net income of $200
each year.
All of the amounts in the income stream are net income, meaning
that each is income minus outgo, or revenue minus cost. In year 0,
the cost exceeds the revenue by $1000. In years 1 though 6, the
revenue will exceed the cost by $200.
This investment evidently has no salvage value. That is, there is
nothing that can be sold in year 6, the last year. If there were, the
amount that could be realized from the sale would be added to the
income amount for year 6.
For simplicity, all my examples have the incomes and outgoes at
one-year intervals. Real-life investments can have income and
expenses at irregular times, but the principles of evaluation are the
same.
Now let's discuss our two measures in connection with this income
stream:
Net Present Value
The net present value of an income stream is the sum of the
present values of the individual amounts in the income stream.
Each future income amount in the stream is discounted, meaning
that it is divided by a number representing the opportunity cost of
holding capital from now (year 0) until the year when income is
received or the outgo is spent. The opportunity cost can either be
how much you would have earned investing the money someplace
else, or how much interest you would have had to pay if you
borrowed money. See the interactive lecture on discounting future
income for more explanation. That tutorial has a niftyspreadsheet
setup for calculating present values that you can copy and use in
your own spreadsheet.
The word "net" in "net present value" indicates that our calculation
includes the initial costs as well as the subsequent profits. It also
reminds
us that all the amounts in the income stream are net profits,
revenues
minus cost. In other words, "net" means the same as "total" here.
The net present value of an investment tells you how this
investment compares either with your alternative investment or
with borrowing, whichever applies to you. A positive net present
value means this investment is better. A negative net present value
means your alternative investment, or not borrowing, is better.
Consider again this income stream:
Year
Let's assume that the discount rate (the interest rate that you could
earn elsewhere or at which you could borrow) will not change over
the life of the project. This makes the calculation simpler. With
this assumption, we can use the usual formula:
Present Value of any one income amount = (Income amount) / ( (1
+ Discount Rate) to the a power)
a is the number of years into the future that the income amount
will be received (or spent, if the income amount is negative).
The net present value (NPV) of a whole income stream is the sum of
these present values of the individual amounts in the income
stream. If we still assume that income comes or goes in annual
bursts and that the discount rate will be constant in the future,
then the NPV has this formula:
The future interest rate does not have to be constant for this
theory to apply. The interest rate can vary, but that makes the
formulas messier. For example, if r1is the expected interest rate
next year, and r2 is the expected interest rate the year after that,
then the present value today of I2 income in year 2 is
I2/(1+r1)(1+r2).
The I 's are income amounts for each year. The subscripts (which
are also the exponents in the denominators) are the year numbers,
3. Changing the discount rate changes the net present value. For
an investment with the common pattern of having costs early and
profits later, a higher discount rate makes the net present value
smaller.
Try it yourself. Click on the discount rate box and change the number there. Then press
Enter.
You
can
also
change
the
income
amounts,
if
you
want.
The
resumes
here:
text
The internal rate of return does not require you to predict future
discount rates. That would seem to make the internal rate of return
The NPV curve, the relationship between the discount rate and the
net present value has a formula that can be written like this:
This, of course, is the formula we saw already for the net present
value, for annualized costs and revenues and a constant discount
rate. Each I is an income amount for a specific year. The
subscripts (which are also the exponents in the denominators) are
the year numbers, starting with 0, which is this year. The
constant discount rate is r. The number of years the investment
lasts is n. In Weeks's study of professionals' incomes, n was about
44, because costs and incomes were calculated from age 21 to age
65.
We'll use an example with an n of 6, so the formula fits on your
screen:
This is our machine investment example that we have been using all
along. The NPV is a function of r. Graphed, it looks like this:
The blue curve shows the net present value for discount rates (r)
from 0 to 0.1 (0% to 10%). The red dots are the two points we get
from our measures. The left red dot shows the net present value
at the discount rate of 0.05 (5%). The right red dot shows the
internal rate of return, because it is where the curve crosses the
horizontal line indicating an NPV of 0. That right red dot is
between the 0.05 and 0.06 marks on ther axis, so the internal rate
This investment is like the first, except that the net profit in years
1 through 6 is $220 per year, rather than $200. I would say that
this investment has a similar "shape" to the first, because the costs
and profits come at the same times. Also, the size of the initial
outlay is the same for both. The only difference is the amount of
profit. Here's a graph with both investments on it:
Year
Green
line $220 $220 $220 $220 $220 $220
investment $1000
Blue
line $0
investment $1000
(modified)
$0
$0
$0
$0
NPV at Internal
0.05
rate of
discount return
rate
$117
0.086
$1550 $157
0.076
The green line invesment has the higher internal rate of return, but
the blue line investment has the higher net present value at a 5%
discount rate. Our two measures are giving us opposite advice!
The graph shows what's going on, by showing the Net Present Value
curves for both investments for discount rates between 0% and
10%. The curves cross at a discount rate of about 0.064, or 6.4%.
Now, to choose which investment we want to do, assuming we
cannot do both, we have to make a guess about what future
discount rates will be. If we expect discount rates to be less than
6.4%, where the curves cross, we choose the blue line
investment. For discount rates above 6.4%, but below 8.56% (the
internal rate of return of the green line investment -- the discount
rate at which the net present value of the green line investment is
$0), we choose the green line investment. At higher discount
rates than 8.56%, we don't do either, because the net present
values are below $0 for both investments.
I've reduced the initial cost, but added a big cost at the end. Let's
see what a difference this makes in how the NPV changes when the
discount rate changes. In the applet below, the starting discount
rate 5%. The net present value (NPV) is -$6. That's negative six
dollars, so if your discount rate really were 5%, you would not want
to do this investment.
Try changing the discount rate, by clicking in the discount rate box
and changing the 0.05 to something else. Try 0.04 or 0.03. In the
examples above, the NPV goes up when the discount rate is
lowered. Is that true for this project? Then try 0.06 or 0.07. What
happens
to
the
NPV?
(Keep the discount rates reasonably small, like between 0.00,
which is 0%, and 0.3, which is 30%.)
The relationship between the discount rate and the NPV is the
reverse of what we see with "normal" investments! With this kind of
income stream, higher discount rates make the net present value
bigger, and lower discount rates make the net present value
smaller.
Before leaving the applet above, see if you can find the internal
rate of return, the discount rate that makes the net present value
equal to $0.
Here
is
the
NPV
graph:
The left blue dot shows the net present value at a 5% (0.05)
discount rate. It is at -$6 on the net present value scale.
The right blue dot is where the curve crosses the discount rate axis,
which is where the net present value is $0. The discount rate
here, 0.054 (5.4%), is the internal rate of return.
Or, at least, it fits the standard definition of internal rate of return.
However, unlike the usual situation, this project is profitable at
interest rates above this IRR and unprofitable at interest rates
below this IRR.
Suppose we have an alternative project which also has this shape,
with a big cost at the end, but slightly lower profits in the
intermediate years. I'll call the new alternative the "green line
investment."
Year
NPV
at Internal
0.05
rate
of
discount
return
rate
Red
line $200 $200 $200 $200 $200 -$6
investment $200
$900
0.054
Green
line $195 $195 $195 $195 $195 -$27
investment
$200
$900
0.070
The green line investment has a lower NPV than the red line
investment at all discount rates, because it has lower profits in
years 1 through 5, and the same costs in years 0 and 6. In
particular, as the table above indicates, it has a lower NPV at the
0.05 discount rate. The graph below shows the NPV curves for both
investments, with the green line lying below the red line at all
discount
rates.
The green line investment is clearly inferior, but it has the higher
internal rate of return. The green line investment's IRR is
0.07. The red line investment's is 0.054.
Thus, for projects with big late costs, the better projects will
have lower internal rates of return, the opposite of the rule for
normal projects that have their costs early and their positive
returns later.
Now let's discover something even more strange. Here's another
applet that lets you change the discount rate and see the effect on
the red line investment's value. This one, though, allows you to
take the discount rate over 0.3 (30%) and all the way up to 1.0
(100%). Those rates are much higher than, hopefully, we will ever
see in the U.S., but they are theoretically possible, and they show a
strange phenomenon.
Try raising the discount rate to 0.3, and notice what happens to the
net present value. Then, raise the discount rate some more above
that.
In which direction does the NPV move now?
See if you can find the second IRR, where the NPV is zero again!
Please do not scroll down past this area until you have answered the
question.
The
resumes
here:
text
Here's the NPV curve for the red line investment for discount rates
from
0%
to
100%.
costs and benefits) or if the project has large late cleanup costs,
then the higher-IRR-is-better rule can steer you to the wrong
investment. Ideally, you want the NPV curve, if you want to
evaluate an investment.
Additional notes
My use of the terms "switch" and "reswitch" refers to the
reswitching controversy of the 1960's. This was between economists
in Cambridge, England, and Cambridge, Massachusetts, over
whether capital markets can be analyzed just like other commodity
markets. The English economists, led by Joan Robinson, argued
that capital markets were special because of the possibility of
reswitching, which raises basic questions about the standard view
that the return to owning capital is a society's reward for abstaining
from consumption.
Some economists would say that only the second of our IRR's is the
true IRR, by defining the IRR as the place where the NPV is
0 and where the NPV is falling. The problems with that are: (1) this
distinction is usually lost in practice, and (2) by making the pattern
of costs and profits more complex, I can make up an investment
that has multiple discount rates where the NPV is 0 and the NPV is
declining.
The oldest discussion of this tutorial's issues that I have found in the
economics literature is Lorie JH, Savage LJ, "Three Problems in
Capital Rationing," Journal of Business, Vol. 28, October 1955.
That's all for now. Thanks for participating! Your comments would
be appreciated! Please e-mail me at sam@sambaker.com