Comparing NPV and IRR Methods with Uneven Cash

Flows
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Note: All IRR and NPV solutions in this lesson are computed using a financial calculator.
Due to rounding errors, solutions may be slightly different if present value tables are used.

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1. Uneven Cash Flows and Your Calculator
1. Operating cash flows are often not at a constant level from period to period. Much
more realistically, these cash flows will be at different levels across the life of the
capital investment, which is more challenging to analyze in your calculator or
spreadsheet (but not much more challenging).
2. The key to analyzing uneven cash flows in your calculator is to locate your cash
flow key. On a Hewlett-Packard™ business calculator, it is the CFj key. On a
Texas Instruments™ calculator, it is the CF key.
3. To use the cash flow key on your calculator, you need to enter all cash flows in
sequential order, beginning with the initial cash investment. Be sure that cash
outflows are indicated with a negative sign before you enter these flows into the
cash flow key.
4. As an example, consider a decision to invest $1,000,000 in one of two different
marketing campaigns: Plan A and Plan B. Plan A has the following set of cash
flows, including the initial net cash investment of $1,000,000.

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5. Note that the net cash investment outflow takes place at time period Year 0, with
the three subsequent after-tax inflows projected in Years 1, 2, and 3. Assuming a
discount rate (also known as a cost of capital rate) of 7%, compute the NPV and
IRR as follows.
1. On various editions of the Hewlett-Packard™ 10Bii+, complete the
following key strokes:
[Gold shift], [C ALL] → to clear all memory
7, [I/YR] → to enter 7% as the annual discount rate
–1000000, [CFj] → to enter –$1,000,000 as the cash outflow at
Period 0.
420000, [CFj] → to enter $420,000 as the first cash inflow at Period
1.
490000, [CFj] → to enter $490,000 as the second cash inflow at
Period 2.
630000, [CFj] → to enter $630,000 as the third cash inflow at Period
3.
[Gold shift], [NPV] → to compute the net present value of all four cash
flows.
Display: 334,776.00
To compute IRR, do not clear the memory.
[Gold shift], [IRR/YR] → to compute the internal rate of return for all
four cash flows.
Display: 23.24

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 2. On various editions of the Texas Instruments™ BA II Plus, complete
the following key strokes:
[CF], [CLR TVM] → to enter cash flow worksheet.
[2nd], [CLR Work] → to clear memory of all cash flow worksheet
computations.
–1000000, [ENTER] → to enter –$1,000,000 as the cash outflow at
Period 0.
[↓] → to move to the next line in the cash flow worksheet.
420000, [ENTER] → to enter $420,000 as the first cash inflow at
Period 1.
[↓], [↓] → to leave F01 as 1 (since this cash flow only occurs once) and
move to the next line in the cash flow worksheet.
490000, [ENTER] → to enter $490,000 as the second cash inflow at
Period 2.
[↓], [↓] → to leave F02 as 1 (since this cash flow only occurs once) and
move to the next line in the cash flow worksheet.
630000, [ENTER] → to enter $630,000 as the third cash inflow at
Period 3.
[NPV] → to start the NPV calculation (the screen should show an “I”)
7, [ENTER] → to enter 7% as the annual discount rate.
[↓], [CPT] → to compute the net present value of all four cash flows.
Display: 334,776.00
To compute IRR, do not clear the memory.
[IRR], [CPT] → to compute the internal rate of return for all four cash
flows.
Display: 23.24
6. Based on these computations, Marketing Plan A provides an NPV of $334,776
and an IRR of 23.24%. Note that with a positive NPV, the IRR is expected to be
higher than the discount rate of 7% used to compute the NPV.
7. Now practice computing NPV and IRR for Marketing Plan B, which has the
following cash flows and also assumes a 7% discount rate (cost of capital). Be sure
to clear your calculator memory before beginning this new analysis.

8. If you handle the calculator computations correctly, you will find that Marketing
Plan B provides an NPV of $407,379 and an IRR of 22.07%.

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2. Comparing NPV and IRR Analysis Methods
1. Note in the example above for Marketing Plans A and B that the NPV and IRR
results are inconsistent. Specifically, the NPV computations indicate that Plan B is
better than Plan A ($407,379 versus $334,776, respectively). On the other hand,
the IRR computations indicate that Plan A is better than Plan B (23.25% versus
22.07%, respectively).
2. NPV and IRR analysis methods do not always provide consistent results when
comparing and choosing investments in capital budgeting. Generally, when the
two methods disagree on how to prioritize different investments, the most
consistently correct comparison method is NPV. This is because the IRR method
is based on an assumption that cash flows can be reinvested elsewhere in the
organization at the same internal rate of return. This assumption is a major
problem in IRR analysis when the internal rate of return of the capital investment
is high (compared to the cost of capital) and cash flows vary substantially from
period to period.
3. The NPV method has the following advantages compared to the IRR method:
1. NPV can adjust the discount rate for different periods of time, which
provides more control in the analysis if different years have different
expectations on risk or inflation.
2. NPV captures the total value (in money) added to the organization based on
capital investment decisions, which provides better decision incentives to
managers who may be worried about maintaining a high average IRR
performance level.
4. The NPV method also has some disadvantages compared to the IRR method,
including the following:
1. NPV results are difficult to evaluate in relative terms. That is, a positive NPV
is good, but how good is a particular dollar amount of a positive NPV? It is
clearer for most business professionals to describe the value of an
investment in terms of a rate of return on the investment.
2. NPV results do not highlight important differences in cash invested when
comparing different capital investment projects. It is hard to compare one
NPV to another unless the initial net cash investments for both projects are
the same.
5. In comparison, the IRR method has the following advantages compared to the
NPV method:
1. IRR provides results that are relatively easier than NPV to describe in terms
of “value” for the organization, i.e., using classic investment rates of return.
2. IRR results are better for comparing performance across different capital
projects when initial net investment amounts are different across the
projects.

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 6. To summarize the lists above, disadvantages of the IRR methods compared to
the NPV method include the following:
1. IRR assumes that cash provided by the investment can be reinvested at the
same IRR, which creates problems in the quality of the analysis at higher
internal rates of return.
2. IRR results are also less reliable with big variations in cash flows, especially
when cash flows vary between negative and positive values.

Marshall Company has purchased a technology patent for $600,000 that is expected to have
a four-year life before the technology becomes obsolete. Marshall will amortize the patent
cost using a straight-line method. In the third year of the patent's use, Marshall expects an
overall cash loss due to halting business while updating and relocating the technology.
Marshall's average income tax rate is 34%, and its cost of capital is 9%. Below are the
computations for the expected after-tax cash flows on this investment. Be sure that you can
reproduce these cash flow computations yourself.

Operating Cash Operating After Tax Total After-Tax Cash

Year $250,000 $165,000 $51,000 $216,000

Year $280,000 $184,800 $51,000 $235,800

Year $(100,000) $(66,000) $51,000 $(15,000)

Year $300,000 $198,000 $51,000 $249,000

What is the NPV and IRR for this patent investment? Use a business calculator to compute
these values.

Answer

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 1. On various editions of the Hewlett-Packard™ 10Bii+, complete the following key
strokes:
[Gold shift], [C ALL] → to clear all memory
9, [I/YR] → to enter 9% as the annual discount rate
–600000, [CFj] → to enter –$600,000 as the cash outflow at Period 0.
216000, [CFj] → to enter $216,000 as the first cash inflow at Period 1.
235800, [CFj] → to enter $235,800 as the second cash inflow at Period 2.
–15000, [CFj] → to enter –$15,000 as the third cash inflow at Period 3.
249000, [CFj] → to enter $249,000 as the fourth cash inflow at Period 4.
[Gold shift], [NPV] → to compute the net present value of all four cash flows.
[Display: −38,551.59
To compute IRR, do not clear the memory.
[Gold shift], [IRR/YR] → to compute the internal rate of return for all five cash
flows.
Display: 5.87
2. On various editions of the Texas Instruments™ BA II Plus, complete the following
key strokes:
[CF], [CLR TVM] → to enter cash flow worksheet.
[2nd], [CLR Work] → to clear memory of all cash flow worksheet computations.
−600000, [ENTER] → to enter −$600,000 as the cash outflow at Period 0.
[↓] → to move to the next line in the cash flow worksheet.
216000, [ENTER] → to enter $216,000 as the first cash inflow at Period 1.
[↓], [↓] → to leave F01 as 1 (since this cash flow only occurs once) and move to the
next line in the cash flow worksheet.
235,800, [ENTER] → to enter $235,800 as the second cash inflow at Period 2.
[↓], [↓] → to leave F02 as 1 (since this cash flow only occurs once) and move to the
next line in the cash flow worksheet.
−15000, [ENTER] → to enter −$15,000 as the third cash inflow at Period 3.
[↓], [↓] → to leave F03 as 1 (since this cash flow only occurs once) and move to the
next line in the cash flow worksheet.
249000, [ENTER] → to enter $249,000 as the fourth cash inflow at Period 4.
[NPV] → to start the NPV calculation (the screen should show an “I”)
9, [ENTER] → to enter 9% as the annual discount rate.
[↓], [CPT] → to compute the net present value of all four cash flows.
Display: −38,551.59
To compute IRR, do not clear the memory.
[IRR], [CPT] → to compute the internal rate of return for all four cash flows.
Display: 5.87

Most capital budgeting projects do not involve consistently even levels of operating cash
flows. Much more typically, operating cash flows levels differ across periods of time, which
complicates the computational analysis. However, most business calculators can handle
uneven cash flows without significant difficulty, but each cash flow needs to be individually

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entered into the calculator using either the CFj key (in most Hewlett-Packard™ business
calculators) or the CF key (in most Texas Instruments™ business calculators). When working
with uneven cash flows, differences can begin to appear in the usefulness of NPV analysis
methods versus IRR analysis methods. These differences are most apparent when dealing
with investments with significantly high IRR rates and with cash flows that vary significantly
across the life of the investment. Generally, when NPV and IRR results conflict with respect
to recommending one investment or another investment, the best approach is to use the NPV
results.

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