Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

IV. Capital Budgeting 9. Net Present Value and

Other Investment Criteria

© The McGraw−Hill^321

Companies, 2002

initial investment) is negative and all the rest are positive. Second, the project must be
independent,meaning that the decision to accept or reject this project does not affect the
decision to accept or reject any other. The first of these conditions is typically met, but
the second often is not. In any case, when one or both of these conditions are not met,
problems can arise. We discuss some of these next.

Problems with the IRR

The problems with the IRR come about when the cash flows are not conventional or
when we are trying to compare two or more investments to see which is best. In the first
case, surprisingly, the simple question: What’s the return? can become very difficult to
answer. In the second case, the IRR can be a misleading guide.

Nonconventional Cash Flows Suppose we have a strip-mining project that requires
a $60 investment. Our cash flow in the first year will be $155. In the second year, the
mine will be depleted, but we will have to spend $100 to restore the terrain. As Figure
9.6 illustrates, both the first and third cash flows are negative.

CHAPTER 9 Net Present Value and Other Investment Criteria 291

FIGURE 9.6

Project Cash Flows

Year

–$60 +$155 –$100

021

SPREADSHEET STRATEGIES

Calculating IRRs with a Spreadsheet

Because IRRs are so tedious to calculate by hand, financial calculators and,

especially, spreadsheets are generally used. The procedures used by various

financial calculators are too different for us to illustrate here, so we will focus

on using a spreadsheet (financial calculators are covered in Appendix D). As the following

example illustrates, using a spreadsheet is very easy.

1 2 3 4 5 6 7 8 9

10

11

12

13

14

15

16

17

ABCDEFGH

Suppose we have a four-year project that costs $500. The cash flows over the four-year life will be

$100, $200, $300, and $400. What is the IRR?

Year Cash flow

0 -$500

1 100 27.3%

2 200

3 300

4 400

The formula entered in cell F9 is =IRR(C8:C12). Notice that the Year 0 cash flow has a negative

sign representing the initial cost of the project.

Using a spreadsheet to calculate internal rates of return

IRR =