1.4 Multiple Internal Rates of Return Sometimes a series of cash fl ows has more than one IRR.

In the
next example we can tell that the cash fl ows in cells B6:B11 have two IRRs, since the NPV graph
crosses the x-axis twice: 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28
29 30 31 A BCDEFGH I Discount rate 6% NPV -3.99 <-- =NPV(B2,B7:B11)+B6 DATA TABLE Discount rate
NPV Year Cash flow -3.99 Table header, <-- =B3 0 -145 0% -20.00 1 100 3% -10.51 2 100 6% -3.99 3
100 9% 0.24 4 100 12% 2.69 5 -275 15% 3.77 18% 3.80 21% 3.02 24% 1.62 27% -0.24 30% -2.44 33% -
4.90 36% -7.53 39% -10.27 Identifying the two IRRs First IRR 8.78% <-- =IRR(B6:B11,0) Second IRR
26.65% <-- =IRR(B6:B11,0.3) MULTIPLE INTERNAL RATES OF RETURN Note: For a discussion of how to
create data tables in Excel, see Chapter 31. -25.00 -20.00 -15.00 -10.00 -5.00 0.00 5.00 0% 10% 20%
30% 40% Net present value Discount rate Two IRRs Excel ’ s IRR function allows us to add an extra
argument which will help us fi nd both IRRs. Instead of writing = IRR(B6:B11) , we write =
IRR(B6:B11,guess) . The argument guess is a starting point for the algorithm which Excel uses to fi nd
the IRR; by adjusting the guess , we can identify both the IRRs. Cells B30 and B31 give an illustration.
28 Chapter 1 There are two things to note about this procedure: • The argument guess merely has to
be close to the IRR; it is not unique. For example, by setting the guesses equal to 0.1 and 0.5, we will
still get the same IRRs: 29 30 31 A BCD Identifying the two IRRs First IRR 8.78% <-- =IRR(B6:B11,0.1)
Second IRR 26.65% <-- =IRR(B6:B11,0.5) • In order to identify the number and the approximate value
of the IRRs, it helps greatly to graph (as we did above) the NPV of the investment as a function of
various discount rates. The internal rates of return are then the points where the graph crosses the x-
axis, and the approximate location of these points should be used as the guesses in the IRR function.
4 From a purely technical point of view, a set of cash fl ows can have multiple IRRs only if it has at
least two changes of sign. Many typical cash fl ows have only one change of sign. Consider, for
example, the cash fl ows from purchasing a bond having a 10% coupon, a face value of $1,000, and 8
more years to maturity. If the current market price of the bond is $800, then the stream of cash fl
ows changes signs only once (from negative in year 0 to positive in years 1–8). Thus there is only one
IRR: 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 A B C DE F G H I J K Year Cash flow Data table: Effect of 0
-800 discount rate on NPV 1 001 B,4E(VPN= --<-- =IRR(B3:B11) 16% -60.62 18% -126.21 20% -183.72
BOND CASH FLOWS: NPV CROSSES X-AXIS ONLY ONCE, SO THERE IS ONLY ONE IRR -400 -200 0 200
400 600 800 1000 1200 0% 5% 10% 15% 20% NPV Discount rate NPV of Bond Cash Flows 4. If you
don ’ t put in a guess (as we did in the previous section), Excel defaults to a guess of 0.1. Thus, in the
current example, IRR(B34:B39) will return 8.78%. 29 Basic Financial Calculations 1.5 Flat Payment
Schedules Another common problem is to compute a “fl at” repayment for a loan. For example: You
take a loan for $10,000 at an interest rate of 7% per year. The bank wants you to make a series of
payments which will pay off the loan and the interest over 10 years. We can use Excel ’ s PMT
function to determine how much each annual payment should be:

This chapter aims to give you some fi nance basics and their Excel implementation. If you have had a
good introductory course in fi nance, this chapter is likely to be at best a refresher. 1 This chapter
covers: • Net present value (NPV) • Internal rate of return (IRR) • Payment schedules and loan tables
• Future value • Pension and accumulation problems • Continuously compounded interest • Time-
dated cash fl ows (Excel functions XNPV and XIRR ) Almost all fi nancial problems are centered on fi
nding the value today of a series of cash receipts over time . The cash receipts (or cash fl ows, as we
will call them) may be certain or uncertain. The present value of a cash fl ow CF t anticipated to be
received at time t is CF r t t ( ) 1+ . The numerator of this expression is usually understood to be the
expected time t cash flow , and the discount rate r in the denominator is adjusted for the riskiness of
this expected cash flow—the higher the risk, the higher the discount rate.
The basic concept in present value calculations is the concept of opportunity cost . Opportunity cost
is the return which would be required of an investment to make it a viable alternative to other,
similar investments. In the financial literature there are many synonyms for opportunity cost, among
them: discount rate, cost of capital, and interest rate. When applied to risky cash flows, we will
sometimes call the opportunity cost the risk-adjusted discount rate (RADR) or the weighted average
cost of capital (WACC). It goes without saying that this discount rate should be risk-adjusted, and
much of the standard fi nance literature discusses how to do this. As illustrated below, when we
calculate the net present value, we use the investment ’ s opportunity cost as a discount rate. When
we calculate the internal rate of return, we compare the calculated return to the investment ’ s
opportunity cost to judge its value. 1. In my book Principles of Finance with Excel (Oxford University
Press, 2nd edition, 2008) I have discussed many basic Excel/fi nance topics at greater length. 14
Chapter 1 1.2 Present Value and Net Present Value Both of these concepts are related to the value
today of a set of future anticipated cash fl ows. As an example, suppose we are valuing an investment
which promises $100 per year at the end of this and the next 4 years. We suppose that these cash fl
ows are risk free: There is no doubt that this series of 5 payments of $100 each will actually be paid.
If a bank pays an annual interest rate of 10% on a 5-year deposit, then this 10% is the investment ’ s
opportunity cost, the alternative benchmark return to which we want to compare the investment.
We can calculate the value of the investment by discounting its cash fl ows using this opportunity
cost as a discount rate: 1 2 3 4 5 6 7 8 9 10 11 12 13 14 A BC D etar tnuocsiD %01 Year Cash flow
Present value 1 5A^)2$B$+1(/5B= --<-- =SUM(C5:C9) Using Excel's NPV function 379.08 <--
=NPV(B2,B5:B9) Using Excel's PV function 379.08 <-- =PV(B2,5,-100) COMPUTING THE PRESENT
VALUE The present value , 379.08, is the value today of the investment. In a competitive market, the
present value should correspond to the market price of the cash fl ows. The spreadsheet illustrates
three ways of obtaining this value: • Summing the individual present values in cells C5:C9. To simplify
the copying, note the use of “ ∧ ” to represent the power and the use of both the relative and
absolute references; for example: = B5/(1 + $B$2) ∧ A5 in cell C5. • Using the Excel NPV function. As
we show on the next page, Excel ’ s NPV function is unfortunately misnamed—it actually computes
the present value and not the net present value.