For uneven cashflow, the best method to calculate the IRR and NPV, excel is the best.
NPV is the net of the discounted CF,j at expected return which relative to present day.
NFV is the net of the compounded CF,j at expected return which relative to future.
Expected return could be risk free rate, inflation, or anything that yu think you need for other evaluation.
This means every project has a NFV and NPV that is use to evaluate the profitability of a project. The project that we discuss here may be investment in equity, UT, real estate, business... that I will share it to you later.
Example 1: A project with 8-years cash flow is tabulated in the table. The table indicates the project have a positive NPV@15% p.a and a positive NFV@15%.
Rules of thumb, based on your expected return input to NPV, said 15%, the discounted for net cashflow produces a positive value. Then, we might accept the project. However, to be specific, IRR has a better meaning than NPV.
IRR is calculated based on the assumption of NPV=0. It is the powerful decision making tool that help me to make the judgment what investment instrument is preferred. IT is termed as CAGR, annualized return, APR, ROI...
However, that was taught from lecturer. I met CFP module 1-6 lecturers, they never mention about XIRR and XNPV. It maybe they do not use XIRR in investment module or maybe they do not even know about EXCEL.
Example 2: In reality, our actual cashflow is complicated (see table 2).The inflow and outflow of a portfolio with different counter are sorted in the table (NOTE: No sorting will return with a wrong IRR, Microsoft shall improve on this XIRR function).Thus, this portfolio has a positive NPV at expected return 15% p.a CAGR. Now, date of transaction is considered in calculation too. You have to liquidate your portfolio, said now.
XIRR is higher than my expected return 15% CAGR but in CFP, lesser than 12% is recommended in calculation. In bullish market, IRR of an aggressive portfolio could simply over 30% p.a, while in bearish it could even lower than -15% p.a We use IRR to compare with the economic indicator not direct return. Direct return has not specific time frame.
Example 3: Bond's coupon rate versus yield-to-maturity. To calculate the CAGR, we all use XIRR for the semiannual coupon. Thus, XIRR takes into the consideration of actual date payment while YTM assumes 360 days a year, or 30 days a month.
Example 4: Project A, B and C comparison.
Obviously,IRR evaluation for the uneven cashflow indicates project A has higher IRR than others. This is how decision is made.
Example 5: Deferred Annuity
You will surprise that the example of the deferred annuity will have a slightly higher IRR that FD rate. However, the only advantages that it could provide is the insurance component built-in inside the policy. For cost effectiveness, UT+termed life maybe have a better return then the annuity.
For 1ook investment, IRR,low = 1.63%, IRR,high = 4.76%, IRR,- = 1.34%
Total,low = RM151,972, Total,high = RM 422,917, Total,- = 140,000.
How about I put 100k to FD and I withdraw 7k yearly at my age 56?
so, what do you think about this annuity product? hmmm.... does your agent know about the fact? hmmm....
Example 6: Have you ever heard about the crab breeding? How NPV and IRR are used in the decision making. Crab breeding is just a background. Capture all the inflow and outflow that expected in the operation. Budget for the business, duration, escape plan .... can be considered inside the plan.
From the plan, you would notice that you have no income that can last for at least 6 months!!! So then you enjoy the value of IRR!!!
Diverted original posting from my facebook note dated 13-Nov-09.
