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1 Part 1. Worksheet for Chapter 11, Capital Budgeting 3/17/03

We go through this model, using the data for Projects S and L as shown below, to calculate Payback, Discounted
2 Payback, NPV, IRR, MIRR, and PI. The model also goes into conflicts between NPV and IRR, multiple IRRs, and
unequal project lives. As such, it deals with most of the BOC questions.

3 Expected A-T Net CF

4 Year Project S Project L Risk-adjusted WACC: 10.00%
5 0 -$10,000 -$10,000 Reinvestment rate: 10.00%
6 1 5,000 1,000
7 2 4,000 3,000
8 3 3,000 4,000
9 4 1,000 6,000
10

Payback : The payback is easy to determine just by looking at the cumulative cash flows from a project, but it is a bit
11 tricky to calculate with Excel. However, the Excel exercise is useful as a way of learning something about Excel's logical
functions, so we explain it in the worksheet named "Payback." Click the tab labeled Payback to see the explanation.
Note, though, that the Excel payback calculation can be omitted without loss of continuity.
12 Project S 0 1 2 3 4
13 Cash flow: -10,000 5,000 4,000 3,000 1,000 From above
14 Cumulative cash flow: -10,000 -5,000 -1,000 2,000 3,000 Calculated in
15 Payback: 2.33 2.33 Payback worksheet
16
17 Project L 0 1 2 3 4
18 Cash flow: -10,000 1,000 3,000 4,000 6,000 From above
19 Cumulative cash flow: -10,000 -9,000 -6,000 -2,000 4,000 See payback
20 Payback: 3.33 3.33 worksheet
21 Discounted Payback
22 Project S 0 1 2 3 4
23 Cash flow: -10,000 5,000 4,000 3,000 1,000 From above
24 Discounted CF: -10000 4545 3306 2254 683 See payback
25 Cumulative cash flow: -10,000 -5,455 -2,149 105 788 worksheet
26 Payback: - 2.95
27
28
29 Project L (Alternative calc) 0 1 2 3 4
30 Cash flow: -10,000 1,000 3,000 4,000 6,000 From above
31 Discounted CF: -10,000 909 2,479 3,005 4,098
32 Cumulative cash flow: -10,000 -9,091 -6,612 -3,606 492 See payback
33 Payback: 0.00 3.88 worksheet
34
35 NPV and IRR
36 Project S 0 1 2 3 4
37 Cash flow: -10,000 5,000 4,000 3,000 1,000 formulas used:
38 NPVS $788.20 =NPV(G4,D40:G40)+C40
39 IRRS 14.49% =IRR(C40:G40)
40
41 Project L (Alternative calc) 0 1 2 3 4
42 Cash flow: -10,000 1,000 3,000 4,000 6,000
43 NPVL $491.77
44 IRRL 11.79%

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Note that Excel's NPV function assumes that the first payment occurs at the end of the first year. In fact, the
investment is made at the beginning of the period. Therefore, we proceed as follows: Click fx > Financial > NPV >
45
OK to get the NPV dialog box. Then specify the cell where WACC is first entered, G4, and specify the range of cash
flows as going from Year 1 through Year 4, D40:G40. Click OK to get the PV of the positive flows. Then edit the
formula by adding the initial cost to get the NPV.

The IRR function assumes that the first cash flow in the specified range is the investment at Year 0, so we can just
46 use the IRR function. Click fx > Financial > IRR > OK, and then specify the range C40:G40. You could make a guess
as to the IRR, but that is not necessary except where multiple IRRs occur. We discuss multiple IRR later in the
spreadsheet.
47
48 NPV Profile Graph
49 We can use the Data Table procedure to calculate NPV for the two projects at different costs of capital, and then
graph the data to create NPV profiles.
50
51 NPV $5,000
52 S L
$4,000
53 WACC $788 $492
S
54 0% $3,000 $4,000 NPVL is $3,000
L
55 5% $1,804 $2,065 Larger $2,000
56 7.17% $1,344 $1,344 Crossover
$1,000
57 10% $788 $492
IRRL $0
58 11.79% $461 $0

59 14.49% $0 -$680 IRRS ($1,000)

-1% 1% 3% 5% 7% 9% 11% 13% 15%
60 15% -$83 -$801
61
We can use Goal Seek to find the crossover rate. First, copy the NPV's to cells C67 and C68 as shown below, and
subtract L from S. Now what we want to do is find the WACC in G4 that forces L to equal S, which means that the
62 difference as shown in C69 will be zero. Put the pointer on C69 and then Click Tools > Goal Seek. Then specify that
C69 is to be set equal to 0 by changing G4, the cell where the WACC first enters the model. When you click OK, G3 will
change to 7.17..., and this is the crossover rate. Record that number and then enter 10% in G4 to restore the
spreadsheet to its original inputs.
63
64 NPVS $788.20 7.17% = Crossover rate.
65 NPVL $491.77
66 NPVS - NPVL $296.43
67
68 MIRR

The regular IRR finds the discount rate that causes the sum of the discounted cash flows to equal 0. The modified IRR
69 first compounds all cash flows the the end of the project's life (generally but not necessarily at the WACC), sums the
compounded cash flows to form the "Terminal Value," and then finds the discount rate that causes the PV of the TV to
equal the cost of the project.
Excel has a built in MIRR function that can be accessed as follows: fx > Financial > MIRR > OK. Then, in the
70 dialog box, insert the range of values for the investment's cost and cash inflows, insert the WACC as the "financing
rate," and insert some assumed reinvestment rate, which normally should be the WACC for reasons explained in the
text. Of course, if some other reinvestment rate is more appropriate, insert it.
71 Regular IRR MIRR
72 ProjectS 14.49% 12.11% The MIRR shows the rate of return the company would actually earn on the
73 ProjectL 11.79% 11.33% project if the cash flows can be reinvested at the WACC. If this reinvestment
74 rate assumption is correct, then the regular IRR overstates the true return.

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75 For this reason, the MIRR is often considered to be the "better" IRR.
76 If the IRR happens to equal the WACC, then the IRR and the MIRR will be
77 equal. Otherwise, they will be different.

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78
Here is a data table that calculates the Regular IRR and MIRR for S and L at different reinvestment rates (or WACCs):
79 Project S Project L
WACC Reg IRR Reg IRR 19.0%
80 MIRR MIRR
17.0%
81 14.5% 12.1% 11.8% 11.3% MIRR-S
15.0%
82 0% 14.5% 6.8% 11.8% 8.8% 13.0%
MIRR-L
83 5% 14.5% 9.4% 11.8% 10.0%

MIRR
11.0%
84 7.17% 14.5% 10.6% 11.8% 10.6% 9.0%
85 10% 14.5% 12.1% 11.8% 11.3% 7.0%
86 11.8% 14.5% 13.1% 11.8% 11.8% 5.0%
87 14.5% 14.5% 14.5% 11.8% 12.5% 0% 4% 8% % % %
12 16 20
88 15% 14.5% 14.8% 11.8% 12.6%
89 20% 14.5% 17.4% 11.8% 13.9% WACC
90 The data table demonstrates these points:
91 1. IRR and MIRR for a project are equal if IRR = WACC. See WACC = 11.8%.
92 2. IRR is independent of WACC, but MIRR increases with the WACC. See IRR and MIRR columns.
3. There can be ranking conflicts between projects based on the MIRR. At WACC's below 7.17%, the crossover rate,
93 MIRRL > MIRRS, but at WACCs above 7.17%, MIRRS > MIRRL.
94
95 Profitability Index (PI), sometimes called the Benefit/Cost Ratio
96
This criterion shows the PV of benefits (inflows) per dollar of investment cost. If it takes several years to build a
97 project, then we would find the PV of the costs. Costs and benefits are both discounted at the WACC. Here are the PI's
for Projects S and L:
98
99 PIS: = PV Inflows / PV Cost
100 = $10,788 $10,000
101 = 1.08
102
103 PIL: = PV Inflows / PV Cost
104 = $10,492 $10,000
105 = 1.05
106
107 The PV of S's inflows exceeds its cost by about 8%, whereas L's benefits are about 5% larger than its cost.
108
109 Assumed MIRRS MIRRL
110 Reinv. Rate 12.11% 11.33% This data table shows that MIRR rankings can conflict
111 0.00% 6.78% 8.78% depending on the reinvestment rate.
112 5.00% 9.45% 10.05%
113 7.17% 10.60% 10.60% This data table shows that MIRR does not depend on WACC:
114 10.00% 12.11% 11.33% MIRRS MIRRL
115 11.33% 12.81% 11.67% WACC 12.11% 11.33%
116 11.79% 13.06% 11.79% 0% 12.11% 11.33%
117 12.11% 13.22% 11.87% 5% 12.11% 11.33%
118 14.49% 14.49% 12.49% 10% 12.11% 11.33%
119 15.00% 14.76% 12.62% 15% 12.11% 11.33%
120

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We have seen that conficts can exist between the NPV and IRR for Projects S and L, depending on the WACC. S's IRR
121 is always higher than that of L (14.49% vs. 11.79%), but L's NPV and MIRR are above those of S if the WACC is below
the 7.17% crossover rate. Similar conflicts could be found with the PI.
The reason for the conflicts is the reinvestment rate assumptions built into the NPV and IRR. NPV assumes
122
reinvestment at the WACC, and IRR assumes reinvestment at the IRR itself.
The condition that caused the conflict was the differing timing of the cash flows for S and L. However, conflicts
123 could also arise if the timing patterns were the same but the sizes of the two projects differed. The following example
demonstrates this point.
124
125 Expected after-tax
126 net cash flows (CFt) NPV Big $788 Big is the winner by NPV
127 Year Big Little NPV Little $162
128 0 -$10,000 -$1,000
129 1 5,000 600 IRR Big 14.5%
130 2 4,000 300 IRR Little 19.2% Little is the winner by IRR
131 3 3,000 400
132 4 1,000 100 So we have a NPV vs. IRR conflict due to size. You could use
133 Goal Seek to learn that the crossover rate for these two
134 projects is 13.96%. If WACC is above 13.96%, Little is better
135 by both the NPV and the IRR criteria.
136 Multiple IRRs
Multiple IRR can exist if a project has non-normal cash flows, i.e., where the sign of the flows changes more than once.
137 The most common situation is where there is a negative cash flow at t = 0, then a stream of positive CF's, and then a
negative CF at the end of the project's life. The follwing example is of this type.
138
139 Year Project M WACC 10.0%
140 0 -$2,000 NPV -$715.25 Regular NPV formula "Guess" takes
141 1 1,000 IRR1 23% IRR formula with guess of 10% us to
142 2 5,000 IRR 2 72% IRR formula with guess of 100% closest IRR.
143 3 5,000 MIRR 7.9% MIRR function with WACC and reinvestment = 10%
144 4 -11,000
145
400
146
147 200 Data for IRR Graph
148 -$715
149 0 10% -715
150 0% 10% 20% 30% 40% 50% 60% 70% 80% 20% -106
-200 30% 152
151
152 -400 40% 224
153 50% 198
154 -600 60% 120
155 70% 19
156 -800 80% -92
157
There are two positive IRR's, but with WACC = 10%, the NPV is negative (at -$715), so the project should be rejected.
158 When you get into multiple IRR situations, you should disregard both of them and focus on the NPV. You could also
calculate the MIRR and compare it with the WACC. Here the MIRR < WACC, so reject.
159

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160 Unequal Lives WACC: 10.00%
161 0 1 2 3 4 5 6
162 CF: Short -$10,000 $4,500 $4,500 $4,500
163 CF: Long -$20,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000
164
165 S L
166 Regular NPV $1,190.8 $1,776.3 Here it looks like L is better by the NPV, but wait!
167 Regular IRR 16.65% 12.98%
168
169 0 1 2 3 4 5 6
170 CF: Short -$10,000 $4,500 $4,500 $4,500
171 -$10,000 $4,500 $4,500 $4,500
172 -$10,000 $4,500 $4,500 -$5,500 $4,500 $4,500 $4,500
173 Ext'nd NPVS $2,085.53 Here we see that NPVS exceeds NPVS.

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1 Part 2. Payback Period & Discounted Payback 3/17/03

2 This worksheet deals more with Excel than with finance, so it can be skipped without loss of continuity. However, it
is useful to learn something about Excel's logical functions, as they come in handy quite often.
3 Project S 0 1 2 3 4
4 Cash flow: -10,000 5,000 4,000 3,000 1,000 Basic cash flows
5 Cumulative cash flow: -10,000 -5,000 -1,000 2,000 3,000 Simple formula
6 0 0 0 1 0
7 Payback: 2.33 0.00 0.00 0.00 2.33 0.00 Logical If function. See below
8 for explanation.
9
10 Project L (Alternative calc) 0 1 2 3 4
11 Cash flow: -10000 1000 3000 4000 6000 Basic cash flows
12 Cumulative cash flow: -10000 -9000 -6000 -2000 4000 Simple formula
13 0 0 0 0 1 Logical If function. See below
14 Payback: 3.33 0.00 0.00 0.00 0.00 3.33 for explanation.
15 `
1. We want to identify when the investment is recovered. We can see, from the cumulative CFs for S, that recovery
16 occurs after Year 2 and before the end of Year 3, so the payback will be 2+ years i.e., during Year 3.

17 2. We want Excel to find the year when cumulative CFs first become positive. The payback is equal to the prior
year plus a fraction, for Project S 2 + a fraction.
3. We could use several procedures, but one way is to first use the LOGICAL "AND" function to find when the
18 year when the cumulative cash flow first becomes positive, as we do on Row 6, and then the LOGICAL "IF"
function to calculate the exact payback given that year.

4. We show just below a picture of the filled-in dialog box for cell C6. First, we with the pointer on C6, we clicked
19 fx > LOGICAL > and > OK to open the box. We are looking for the situation where the cumulative cash flow first
becomes positive. This means that the prior year's CF is negative and this year's CF is positive., i.e., B5<0 and
C5>0. We used the AND Statement to determine if these conditions were met, and we copied that formula into cells
D6:G6. We got FALSE for all years except Year 3, so the payback is 3 plus a fraction.

20

21

22
23
24

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5. Next, in C7, we put in an IF statement that causes the payback to be shown if Row 6 shows TRUE and 0 if Row 6
shows FALSE. The first item specifies that the criterion is that F6=TRUE. If that condition does not hold, then 0 is
25 placed in C7. However if F6=TRUE, then the payback, is placed in C7. The payback formula is shown in the
second row of the dialog box, and it is equal to the number for the prior year plus the fraction of the current year
that it takes the year's cash flows to cover the prior year's negative cumulative cash flow: E5/F4. However, E5 is a
negative number, and to make the formula operate properly, we need to add the fraction. Otherwise, we get an
incorrect payback value. So, we need the absolute value (i.e., the positive) of the fraction. Excel gives the absolute
value for a cell by entering ABS(cell reference), e.g., ABS(E5/F4). The final result is the formula shown in the
second row of the dialog box. This formula is then copied into the other cells on Row 7.

26

27
6. Once the payback has been calculated on row 7, we want to show it in Cell B7. We do that by putting the pointer
28 on cell B7 and then clicking fx > Statistical > MAX and then specifying the relevant range and clicking OK. That
puts the value 2.33 in cell B7.
29 8. This same process is repeated to find Project L's payback.

As we noted at the outset, in a simple problem such as this it is easier to calculate the payback
30 with a calculator than with Excel. However, if you were setting up a model to examine many
projects, the Excel approach would be superior. Also, Excel's logical functions are useful in
many situations, so it is helpful to learn how to use them.
31
32 Discounted Payback. WACC = 10%
33
34 To find the discounted payback, find the PV of each cash flow, discounted at the WACC, and proceed as before.
35
36 Project S 0 1 2 3 4
37 Cash flow: -10,000 5,000 4,000 3,000 1,000 Basic cash flows
38 Discounted CF: -10000 4545 3306 2254 683
39 Cumulative cash flow: -10,000 -5,455 -2,149 105 788 Simple formula
40 Payback: - 0.00 0.00 0.00 2.95 3.15 Logical If function used differently.
41 One less step.
42 Project L (Alternative calc) 0 1 2 3 4
43 Cash flow: -10,000 1,000 3,000 4,000 6,000 Basic cash flows

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44 Discounted CF: -10,000 909 2,479 3,005 4,098
45 Cumulative cash flow: -10,000 -9,091 -6,612 -3,606 492 Simple formula
46 Payback: - 0.00 0.00 0.00 0.00 3.88 Logical If function used differently.

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