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36 - General Principles of Financial Planning E Example 4: Finding the monthly payment in an annuity due (1) Calculate the annual payments received at the beginning of each month for 10 years from an investment of $50,000 earning an annual return of 7 percent, compounded monthly (2) First, put your calculator in the begin mode (3) Solution: 120 N (10 12), 5833 (7/12) I, 50,000 PV, CPT PMT $57717 4 Net present value (NPV) A Net present value is the amount of cash ow (in present value terms) that a project generates after repaying the invested capital and required rate of return on that capital B If the project generates a positive NPV, then shareholder wealth increases In contrast, a negative NPV will decrease shareholder wealth C NPV is considered better than internal rate of return (IRR) because it measures pro tability in dollars added to shareholder value In contrast, IRR measures pro tability as a rate of return D NPV assumes that the reinvestment rate of cash ows is the cost of capital, whereas IRR assumes that the reinvestment rate is the IRR E When the IRR is equal to the cost of capital, the NPV will be zero If the IRR is less than the cost of capital, the result is a negative NPV F Example: Calculate the NPV of a project with an initial cost of $2,000 that produces the following cash ows (CF): year (1) +1,000; year (2) +500; year (3) +700; year (4) 500; year (5) +300 The cost of capital is 5 percent Solution: 2,000[CF0]; 1,000 CFj; 500 CFj; 700 [CFj]; 500 [CFj]; 300 [CFj]; 5 [I]; [NPV] $16571 5 Internal rate of return (IRR) A The IRR calculates the rate of return at which the present value of a series of cash in ows will equal the present value of the project s cost B It is also de ned as the rate of return in which the net present value of a project is zero It assumes that all cash ows are reinvested at the IRR C The IRR is equivalent to the yield to maturity (YTM), the geometric average return, and the compounded average rate of return D If IRR is less than the cost of capital, reject the project If IRR is greater than the cost of capital, accept the project E Example: Calculate the IRR of a project that has an initial out ow of 5,000 and will generate the following cash ows: year (1) 3,000; year (2) 500; year (3) 2,500; year (4) 500; year (5) 1,500 Solution: 5,000[CF0]; 3,000 CFj; 500 CFj; 2,500 [CFj]; 500 [CFj]; 1,500 [CFj]; [IRR] 1409 percent 6 Irregular cash ow A It is common for the stream of cash ows to change from year to year for projects or investments, so it is not an annuity The uneven cash ow is simply just a stream of (annual) single cash ows B To determine the FV/PV of irregular cash ows, you need to nd the FV/PV of each cash ow and then add them up The PV of an uneven cash ow stream is also calculated using the NPV function on your calculator C Example 1: Calculate the present value of an neven cash ow series using a 10 percent discount rate and PV1 though PV5 Assume cash ows are:.



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