To: VP of Accounting

From: Danita Vaughan

Date: January 23, 2011

NPV: Define, explain, and provide examples.

Net present value is a discounted -cash-flow method for analyzing the time value of money.

This method is generally used for projects lasting more than one year; it also identifies the

difference between an investments market value and its costs. Considering the time value of

money, financial analysts use it to determine whether or not to take on long-term projects (Ross,

Westerfield & Jordan, 2010). The rule of thumb for NPV is that if the value is zero or positive

the company should accept the proposal but if the NPV is negative the company should reject the

proposal, as it would not be a good investment. Another factor is whether or not the sum of the

present values is as high as the hurdle rate; if it does exceed it then it is indicative that the project

should be accepted.

One of the most essential decision makers in applying the net present value method is the

selection of an appropriate discount rate. The discount rate is indicative of the risks associated

with the investment including the length either short or long-term. A high discount rate can be

the result of a risky investment or a short-term project.

The net present value of an investment tells you how this investment compares with your

alternative investment or with borrowing, whichever applies to you.

Here is an example of the NPV calculation:

“Suppose we'd like to make 10% profit on a 3 year project that will initially cost us $10,000.

a) In the first year, we expect to make $3000

b) In the second year, we expect to make $4300

c) In the third year, we expect to make $5800 (Auerbach, n.d.).”

IRR: Define, explain, and provide examples.

The IRR is the interest rate that is equal to the present value of the cash flow of an investment

account (Hilton, 2008). The internal rate of return is also a discounted cash flow method utilized

to determine if the discount rate of the projects present value of the projects benefits is equal to

the proposed present value of our investment. “The internal rate of return is the true economic

return earned by the asset over its life (Hilton, 2008).” The discount rate makes the net present

value of an investment equal to zero (Baker, 1997 - 2006). The IRR is considered acceptable

when it is higher than the return, other than that it should be rejected (Ross et al, 2010). Meaning

the IRR should be higher the than discount rate.

Internal rate of return allows the financial analyst to consider the time value of money; it also

allows you to figure the amount or interest rate of the return to expect from the project. “The

internal rate of return method (IRR) is computed by finding the discount rate that equates the

present value of a project's cash outflows with the present value of its cash inflows (Capital

Budgeting Process, 2010).” To determine the IRR you would take the amount of the investment

and divide it by the company’s annual cash inflows.

When using IRR, some key points to recognize are that the discounted rate is based on the

company’s portfolio, so you should only take on projects that will increase your portfolio. One

way to verify the discount rate is the use of a present value table, in this you should look for the

number that is closest to our calculation. This percentage is our discount rate. If the discount rate

is 14% then we should only take on projects that are 15% or higher; we would in turn reject the

projects whose IRR falls below the discount rate.

To further understand the calculation of the internal rate of return is the following example:

• “Where the initial payment (CF1) is $200,000 (a positive inflow)

• Subsequent cash flows (CF 2, CF 3, CF N) are negative $1050 (negative because it is being
 paid out)

• Number of payments (N) is 30 years times 12 = 360 monthly payments

• Initial Investment is $200,000

• IRR is 4.8% divided by 12 (to equate to monthly payments) = 0.400%

(Grayson, n.d.)”

MIRR: Define, explain, and provide examples.

Based on the assumption that all a projects investments are reinvested at the internal rate of

return, MIRR is used to reflect the profitability of an investment. Because the regular internal

rate of return may not give you the values needed we have a modified internal rate of return,

MIRR reduces the shortcomings of the internal rate of return. The modified internal rate of return

believes that all the cash flows are reinvested within the company’s cost of capital. Thus the

MIRR has the ability to give a more accurate assessment of the investment or project. MIRR is

the IRR for a project with a matching level of investment and NPV to that being measured but

with a single final payment.

Indeed, one assumption of the MIRR is that the project is not capable of generating cash
flows as forecasted and that the project’s NPV is exaggerated. However there are significant

advantages of the MIRR technique are that its computations are quicker and do not give the

multiple answers that can occur with the normal IRR (Ryan, 2006). MIRR appears to be a more

accurate discounted-cash-flow method for certain types of projects.

An example of modified internal rate of return follows. For our example, we must first

calculate the MIRR, to accomplish first “find the FV of the cash flows at 12% (the WACC):

FVCF = 2000( 1.12) + 2500( 1.12) + 3000( 1.12) + 3500( 1.12) + 4000 = 18,342.56
4 3 2 1

This is the amount that you will have accumulated by the end of the life of the investment

Now, find the average annual rate of return:

18342.56
MIRR = 5 −1 = 12.899%
10000

Since the MIRR is greater than the WACC, this project is acceptable (MIRR, 2007 - 2011).”

References:

Auerbach, R. (n.d.). How to calculate net present value (NPV). Retrieved January 23, 2011

from: http://www.ehow.com/how_2187130_calculate-net-present-value-

npv.html#ixzz1BvCa9Ymg

Baker, S. L. (2000). Perils of the internal rate of return. Retrieved January 23, 2011, from:

http://hadm.sph.sc.edu/courses/econ/invest/invest.html

Grayson, L. (n.d.). Internal rate of return: An inside look. Retrieved January 23, 2011 from:

http://www.investopedia.com/articles/07/internal_rate_return.asp

Mayes, T. R. (n.d.) Investment criteria. Retrieved January 23, 2011 from:

clem.mscd.edu/~mayest/FIN3300/Files/ch9.ppt

MIRR Modified Internal Rate of Return. (2007 - 2011). Retrieved January 23, 2011 from:
 http://finance.thinkanddone.com/mirr.html

Ross, S. A., Westerfield, R. W. v& Jordan, B. D. (2010). Fundamentals of corporate finance.

McGraw Hill/Irwin: New York, NY

Ryan, R. (2006). Corporate Finance and Valuation. Thomson Learning: London, UK