UVA-QA-0518

EVALUATING MULTIPERIOD PERFORMANCE

A tract of land is developed for the resale value of the lots into which it will be
subdivided. A promising new product is nationally introduced on the basis of its future sales and
subsequent profits. A piece of equipment is ordered for the improved operating efficiency and
increased capacity that it will provide relative to the piece it replaces. A corporate bond is
purchased for its coupons and the ultimate repayment of its par value.
These decisions are similar in that each requires the investment of money in anticipation
of benefits whose realization will be spread over time. The value of such an investment depends
on many factors including: the magnitude of the benefits, the timing of those benefits, and the
degree of uncertainty in actually receiving the anticipated benefits. Although the prediction of
future benefits is perhaps the most significant challenge in appraising investments, the careful
and consistent consideration of the effects of time is necessary, even when those benefits are
known. Suppose the monetary return of an investment far exceeds the initial investment, but the
return is delayed into the distant future. Does the magnitude of the return justify the wait?
Suppose one investment yields greater monetary returns than another does, but the returns of the
first extend over a longer period than the second. Which is better or is either desirable?
This note offers a systematic approach to answering these questions. The focus will be
on the measurement of the monetary returns of an investment (cash flow) and on the evaluation
of the effects of timing on the value of those returns (discounted cash flows). The discussion
assumes that the returns are known with certainty. The concepts and techniques for explicitly
addressing uncertainty are discussed in other notes.

Cash Flow
Why is real estate developed, a new product introduced, equipment replaced, or a bond
purchased? In each decision, there are a host of reasons, ranging from the strategic goals of the
firm to the personal desires of the manager. Common to almost all investment decisions,
however, is the objective of earning financial returns from the invested money. This section

This technical note was prepared by Sherwood C. Frey Jr., Ethyl Corporation Professor of Business Administration.
Copyright 1996 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved.
To order copies, send an e-mail to sales@dardenbusinesspublishing.com. No part of this publication may be
reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means
electronic, mechanical, photocopying, recording, or otherwisewithout the permission of the Darden School
Foundation.

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concentrates on the identification and measurement of these financial returns and ignores the
other more subjective considerations that significantly influence investment decisions.
Simply stated, the returns from an investment can either be reinvested in the firm or
distributed to the shareholders. As a result, the returns from an investment should be viewed as
usable funds generated by the investment, and the outlays for an investment should be
regarded as the money withdrawn from the pool of usable funds. Usable funds are cash, and thus
investments should be evaluated in terms of cash flowthe inflow and outflow of usable
fundsand not in terms of the profits which are reported by the firms accounting system.
Profits and cash flow are not the same. As an illustration of this difference, suppose a manager
were offered the choice between prepaying the entire premium of $15,000 for a three-year
insurance program or paying the premium in three annual installments of $5,000 each. Almost
certainly, the manager would select the installment option. But why? For each payment option,
the firms income statement would report the same annual insurance cost of $5,000 (accrual
accounting methods require that the prepayment be spread evenly over the three-year life of the
policy), and hence the same profits would be reported for both plans. The difference between the
two options lies in their differing schedules of demand for cash, that is, their differing cash
flows. The installment plan is preferred because it actually spreads the payments over three
years. Focusing on the cash flow reveals the advantage while considering profits obscures it.
The common practice in calculating cash flows for an investment is to calculate the
incremental cash flows of the investmentthe difference between the cash flows from the
investment and the cash flows of a do-nothing alternative. If there are several alternative
investments, several cash flow calculations are required, one for each investment relative to the
same do-nothing alternative. In addition to calculating the cash flows on an incremental basis,
one must take care to distinguish between items that are really cash flows and those noncash
items masquerading as cash flows which result from accounting conventions. A simple rule
states that if you write a check for it, its a cash outflow; if you can deposit it in the bank, its a
cash inflow. In the above insurance example, the prepayment option has a cash outflow of
$15,000 now and no cash outflows in the subsequent years, regardless of how the payment may
be expensed over the life of the policy.
Making an exhaustive list of the sources of cash flows is impossible, but the cash flows
that are most commonly encountered in practice can be grouped into several comprehensive
categories. When calculating the initial outlay of an investment, look first for the obvious initial
purchase or construction cost and then note any changes in working capital (the holding of cash,
inventories, the net of accounts receivable and accounts payable) required to support the project,
the salvage value of any equipment that is being replaced or discarded, and any investment
incentives offered by the tax authorities. For cash flows subsequent to the initial outlay, look for
revenues (sales, dividends, or interest payments if it is a purely financial investment) resulting
from the investment, for cost of goods sold (materials, manufacturing costs), for changes in
selling and administrative expenses, for any subsequent investment costs, and for taxes. Avoid
expenses that do not change if the investment is not done, but are allocated to the investment as
if they were incremental. Do not credit the investment with sales that are cannibalized from

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existing sales. At the end of the life of the investment, be sure to include the recovery of
working capital, any shutdown costs, and the salvage value of any equipment.
Note that neither depreciation nor financing expense is included as a cash flow.
Depreciation is simply an accounting provision whose effects are reflected in the calculation of
taxes, but is not itself a cash flow. The financing costs of an investment are excluded because of
the widely accepted practice of separating the evaluation of the investment itself from the
financing of the investment. There are several reasons for keeping these two considerations
separate. A firms portfolio of investments is generally funded from capital that is raised through
a combination of debt, equity, and retained earnings. Without the perspective of the entire
demands for capital within the firm, it would be inappropriate to assume the cost on any one of
these sources (or any mix) in evaluating a specific project. Even if an investment were clearly to
be financed out of either debt or equity but not both, the cost of either means would not reflect
the real cost of financing because the funding of the investment would affect the firms ability to
acquire future capital by either means.1 Thus, the financing decision is a corporation-wide
decision and should not be implicitly made (or assumed) at the level of an individual investment
decision.
An example
As an illustration of these concepts, consider a proposed investment of $128,000 that will
expand production operations for three years and allow the firm to satisfy demand that is
currently being lost. The anticipated revenue from the incremental sales will be $108,000 with a
cost of goods sold of $48,000. Although the company allocates its selling and general
administrative expenses as 12 percent of revenue, there would be no increase in the actual selling
and administrative expenses. To support the increased sales volume, $32,000 must be set aside
at the time of the investment to cover increases in inventories and accounts receivable, all of
which will be recoverable at the end of the third year. At the end of the third year, there will also
be usable equipment with a salvage value of $8,000. The initial investment will be straight-line
depreciated so that the book value is $8,000 at the end of the third year. The marginal tax rate
(federal as well as state and local) is assumed to be 38 percent.
The cash flows for this investment are shown in Table 1. Note that the flows during each
year have been aggregated to give an annual total even though most of them will actually occur
continuously during the year. In addition, revenues are just from the incremental sales, and the
increased allocation of selling and administrative expenses is not included because the actual
selling and administrative expenses do not increase because of the investment. The format of
Table 1 highlights the actual cash flows by never including directly in the calculations any noncash items such as depreciation. As a result, taxes are computed as a side calculation. An
1

An exception to this statement would occur when the financing of an investment is specific to the investment
itself and the firm is insulated from any risks associated with the investment. Some real estate projects may be
financed in this fashion. When these conditions apply, the investment is de facto a separate entity and the terms of
the financing are integral to the project. As a result, neither the investment nor the financing of the investment can
be isolated from the other and the two must be treated together.

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alternative format that many find useful follows the layout of an income statement. This format
will yield the same results as long as the noncash items that have been included in the calculation
of profits before tax are added back to convert profits after tax into cash flows. Table 2
presents the calculation of the cash flows for the example using the income statement format.

Table 1
Cash Flows

Now
Cost of project
Sales
Cost of goods sold
Taxes (Note 1)
Changes in working capital
Salvage of equipment
Taxes on salvage (Note 2)

$(128,000)

Total cash flow

$(160,000)

Note 1: Tax computation

Sales
Cost of goods sold
Depreciation
Profits before taxes
Taxes (38% of profit)

Year 1

Year 2

Year 3

$108,000
(48,000)
(7,600)

$108,000
(48,000)
(7,600)

$108,000
(48,000)
(7,600)
32,000
8,000
0

$52,400

$52,400

$92,400

(32,000)

$108,000
(48,000)
(40,000)
20,000
$7,600

Note 2: Because the equipment is sold at book value, there is no capital gain or loss on the sale
and taxes are zero.

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Table 2
Cash Flows: Income Statement Format

Now
Cash flow of initial investment

Year 1

Year 2

Year 3

$(128,000)

Sales

$108,000

$108,000

$108,000

Cost of goods sold

Depreciation
Total cost

48,000
40,000
$88,000

48,000
40,000
$88,000

48,000
40,000
$88,000

Before tax profits from sales

Taxes (38% of profits)
Aftertax profits from sales
PLUS: noncash charges to sales (Note 1)
Cash flow from sales

20,000
7,600
12,400
40,000
$52,400

20,000
7,600
12,400
40,000
$52,400

20,000
7,600
12,400
40,000
$52,400

Salvage of equipment
Book value of equipment
Profits from equipment salvage
Capital gains tax
Aftertax profits from equipment salvage
PLUS: noncash charges to equipment salvage
Cash flow from equipment salvage

$8,000
8,000
0
0
0
8,000
$8,000

Cash flow from working capital

32,000

Total cash flow

(32,000)

$(160,000)

$52,400

$52,400

$92,400

Note 1: Because noncash items (depreciation and book value of equipment) are subtracted in
calculating aftertax profits, these items must be added back to convert profits into cash flow.

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Time Value of Money

Once the cash flows for a proposed investment have been calculated, it still must be
determined whether the proposal is a sound investment. In addition, if a choice must be made
between mutually exclusive alternatives or if there are several attractive alternatives but limited
available capital, managers must evaluate the alternatives to determine which ones make the
most effective use of the invested funds. This section presents a systematic way to make these
evaluations.
Suppose a manager is faced with a choice between two investment opportunities, A and
B, each of which requires an initial investment of $50,000. Investment A produces cash flows of
$22,000 at the end of each of the next three years. The cash flows of investment B are $12,000
at the end of the next two years and $46,000 at the end of the third year. Which investment, if
either, should the manager select?
Accumulated value
Over its lifetime each alternative will return more than the initial investment of $50,000:
$66,000 for investment A, $70,000 for investment B. At first blush, it would appear that both
investments are attractive and that investment B is better because it returns more for the same
initial investment.
Such an initial reaction should be tempered, however, by the realization that in the early
years the cash flows from investment A exceed those from investment B. Because the manager
would certainly not leave the cash flows idle from either of the investments, the larger earnings
from the reinvestment of the larger flows from investment A in years 1 and 2 could offset
investment Bs larger cash flow in year 3. The extent to which the larger reinvestment earnings
will benefit investment A depends upon the attractiveness of the reinvestment opportunities.
Assume that the manager will aggressively manage any cash returns so that they would earn 15
percent after taxes. With this reinvestment environment, what would be the total value
(including reinvestment) of each of the alternatives at the end of its lifetime?
A manager can answer this question with a calculation that is identical to the calculation
of the balances in a savings account. For a savings account, the interest rate is applied to the
average balance in the account, and the ending balance for a time period is the total of the
opening balance, the interest earned, and any deposits or withdrawals made during the time
period. In the investment example, the returns from the investments are like the deposits to the
savings account, and the earnings from reinvesting the returns are like the interest payments.
More specifically, for investment A, there are zero dollars on deposit during year 1, so no
interest is earned, but a deposit of $22,000 is made at the end of the year. For year 2, the opening
balance of $22,000 is invested throughout the year. That balance will earn $3,300 in interest at a
15 percent rate. At the end of year 2, the balance will be $47,300the sum of the opening
balance of $22,000, the interest of $3,300, and year-end deposit of $22,000. Similarly, the
balance at the end of year 3 will be $76,395the sum of the opening balance of $47,300, the

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interest earned during the year of $7,095 ($47,300.15), and the year-end deposit of $22,000.
Table 3 presents these calculations for investments A and B.
When the two investments are evaluated in light of the 15 percent reinvestment
opportunities for their returns, investment A is preferred because it accumulates $76,395 by the
end of year 3, as compared to the $75,670 accumulated by investment B. Even though
investment A offers a smaller total return, those returns come earlier and permit greater earnings
from reinvestment. The figures in Table 3 show that the earlier cash flows of investment A earn
$10,395 in reinvestment income compared to the $5,670 for investment B. The added
reinvestment earnings of investment A are sufficient to offset the $4,000 difference in total
return.
If the managers reinvestment opportunities were less attractive, investment A might not
be the more attractive choice. Suppose the reinvestment opportunities were 10 percent instead of
15 percent, which investment would be the better? Table 4 presents the same calculation as
Table 3 but with a reinvestment rate of 10 percent. Now, investment B has the greater
accumulated value at the end of year 3 and is the more attractive investment. At this lower
reinvestment rate, the accelerated cash flows of investment A do not earn sufficient reinvestment
income to offset the $4,000 difference in total return.
The above examples show that the evaluation of investments whose payoffs extend into
the future depends not only on the magnitude of the cash flows but also on the timing of the
flows and the subsequent use to which those flows can be put. To appropriately evaluate
alternative cash flow streams, one must consider all three aspectsmagnitude, timing, and
reinvestment rate.
Thus far, the analysis of the two investments has compared only the two alternatives, but
has not determined if either of them is an attractive use of the $50,000 initial investment. Would
it be better to put the $50,000 into the 15 percent investment opportunities rather than either of
the two alternatives? One way to answer this question is to calculate the accumulated value of
$50,000 after three years and compare it with the accumulated values of the two investment
alternatives. At a 15 percent rate with the earnings from one year reinvested for the next, the
$50,000 will compound to $57,500 at the end of the first year, $66,125 at the end of the second
year, and $76,044 at the end of third year.2 Comparing this final figure to the accumulated value
of investment A ($76,395) shows that investment A is a slightly better use of the $50,000 than
simply investing in the available 15 percent opportunities. On the other hand, investment B
($75,670) is not a sound investment when 15 percent opportunities exist. What do you expect to
happen if the investment opportunity rate were 10 percent? Check your intuition with a
numerical calculation similar to the one just performed.

The exact number (at the end of the third year) is $76,043.75, but to simplify the presentation, figures will be
rounded to whole dollars.

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Table 3
Comparing Investment A and Investment B
(reinvestment at 15 percent)

Investment A
Year 1

Year 2

Year 3

$0

$22,000

$47,300

3,300

7,095

Cash inflow at end of year from

Investment A

22,000

22,000

22,000

Total cash available at end of year

for reinvestment next year

$22,000

$47,300

$76,395

Year 1

Year 2

Year 3

$0

$12,000

$25,800

1,800

3,870

Cash inflow at end of year from

Investment B

12,000

12,000

46,000

Total cash available at end of year

for reinvestment next year

$12,000

$25,800

$75,670

Cash balance at beginning of year

Earnings from reinvestment of
balance at 15 percent

Investment B

Cash balance at beginning of year

Earnings from reinvestment of
balance at 15 percent

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Table 4
Comparing Investment A and Investment B
(reinvestment at 10 percent)

Investment A
Year 1

Year 2

Year 3

$0

$22,000

$46,200

2,200

4,620

Cash inflow at end of year from

Investment A

22,000

22,000

22,000

Total cash available at end of year

for reinvestment next year

$22,000

$46,200

$72,820

Year 1

Year 2

Year 3

$0

$12,000

$25,200

1,200

2,520

Cash inflow at end of year from

Investment B

12,000

12,000

46,000

Total cash available at end of year

for reinvestment next year

$12,000

$25,200

$73,720

Cash balance at beginning of year

Earnings from reinvestment of
balance at 10 percent

Investment B

Cash balance at beginning of year

Earnings from reinvestment of
balance at 10 percent

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Present value and net present value

In the above discussion, the evaluation of a stream of cash flows was based on the
accumulated value (including reinvestment income) of the cash flows to the end of the streams
lifetime. This is a very natural way to approach the evaluation because it so closely parallels the
compounding calculations of a savings account. There are, however, several drawbacks to this
future value approach. First, the value of an investment is associated with a future point in
time. For short-lived investments, as in the examples, this is not a problem. For investments
with long lifetimes, say 20 or 40 years, it is very difficult to internalize the significance of their
accumulated values. The numbers will be extraordinarily large and very distant in time. Even if
the investments under consideration have moderate lifetimes, they may be of different lengths.
As a result, their evaluations will be associated with different points in time, making comparison
difficult. Finally, the financial attractiveness of each investment would require the calculation of
two accumulated valuesone for initial investment and one for the future cash flows.
If the perspective of the evaluation were changed from future dollars to today dollars,
these difficulties would be eliminated. The frame of reference would be today, not some distant
time; all investments would be evaluated at a common point in time, today, not potentially
different points; the attractiveness of an investment could be based on the simple comparison of
the initial investment and the today value of the future cash flows.
From the future dollars perspective, $50,000 today is worth $76,044 in three years in an
environment of 15 percent reinvestment opportunities. (This figure was calculated in the
previous section.) If we shift our perspective to today, it could be said that $50,000 is the present
value of $76,044 received three years from now when 15 percent opportunities exist. The
$50,000 is the present value in the sense that if it were invested today at 15 percent it would
grow to $76,044 three years in the future. As a result, $50,000 today and $76,044 in three years
are financially equivalent when 15 percent investments are available. This leads to the definition
that the present value of a future payment is the amount today for which the investor is
indifferent between receiving the present value or waiting for the future payment.
This concept can be applied to a stream of future cash flows, for example, the three
annual payments of $22,000 that make up the returns from investment A. The present value of
these flows at a reinvestment rate of 15 percent would be the amount of money required today to
generate the future stream of cash flows. Each of the individual cash flows in the stream has a
present value (the amount required today to generate it). The sum of these individual present
values would be the amount required to generate the entire stream. Because the accumulation
over time of a reinvested dollar is the underlying concept of present value, the following table of
the accumulated value of a reinvested dollar at 15 percent will help in calculating the present
values of each of the cash flows resulting from investment A.

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Year 1

Beginning amount
Interest at 15 percent
Ending amount

Year 2

Year 3

1.0000

1.1500

1.3225

.1500

.1725

.1984

1.1500

1.3225

1.5209

The first component of investment A stream is $22,000 one year from now. A dollar that is
invested at 15 percent will accrue to $1.15 one year from now. Thus, $22,000 equals 115
percent of the amount that would be necessary to invest today to have $22,000 at years end.
The present value of $22,000 is therefore $19,130 ($22,000/1.15). Similarly, the cash flows of
years 2 and 3 of investment A would require $16,635 (or $22,000/1.3225) and $14,465 (or
$22,000/1.5209), respectively. The entire cash flow stream would require an investment at 15
percent of the sum of these individual investments, $50,230 ($19,130 + $16,635 + $14,465).
This sum is the present value of the stream of future cash flows of investment A.
Because it would take $50,230 to generate the stream of future cash flows of investment
A with 15 percent investments and investment A requires an initial investment of only $50,000,
investment A is an attractive investment when 15 percent alternatives are available. Not
surprisingly, because present value and accumulated value are so tightly related, this is the same
conclusion that was reached when comparing the accumulated value of the cash flow stream of
investment A to the accumulated value of $50,000 after three years. If investment A were made,
it would add today $230 ($50,230 $50,000) in value above of the use of the $50,000 in the
managers usual 15 percent investments. The difference between the present value of the future
cash flow stream and the initial investment is called the net present value. The net present
value (NPV) is a measure of the attractiveness of an investment. If the NPV is positive, an
investment is attractive, because it would require more money to generate the investments future
cash flows through the managers reinvestment opportunities than is required by the investment
itself. Value is being added by positive NPV investments, and the more positive the NPV, the
more attractive the investment. If the NPV is negative, the investment is unattractive, and value
is depleted. If the NPV is zero, the investment is equivalent to earning the reinvestment rate, and
the investment neither adds nor depletes value. As such, a zero NPV investment is an indifferent
opportunity.
Note that in the above calculations, the present value of a future cash flow is less than the
cash flow itself. The future flows have been discounted to account for the time value of
money. At a 15 percent reinvestment rate, $22,000 received one year from now has a present
value of $19,130 or .8696 of its future value. To account for the time value of money, the flow
one year from now must be multiplied by the factor, .8696, to bring the flow to its present value.
This factor is the one year discount factor at 15 percent. Similarly, the discount factors at 15
percent are .7561 for two years and .6575 for three years. Each of these can be easily calculated
as the reciprocal of the accumulated values of a dollar: .8696=1/1.15, .7561=1/1.3225, and

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.6575=1/1.5209. Discount factors can be interpreted as the present values of future one dollar
payments and can be used to calculate the present value of future streams of cash flows. For
investment A, the calculation is:
($22,000 . .8696) + ($22,000 .7561) + ($22,000 .6575) = $50,230
Formulas for accumulated and present value calculations
Underlying the calculations of accumulated value and present value are several straightforward equations. The accumulated value, A, at reinvestment rate, r, of a single payment, P,
after one year is P (1+r), the payment P plus the interest rP. After two years, the accumulated
value is [P (1+r)] (1+r), the amount after one year multiplied by 1+r. The accumulated values
in subsequent years would be calculated by the successive multiplications of the ending value by
1+r. This would yield the general formula for the accumulated value after n years, A n, of a
payment, P, at a reinvestment rate, r:
An = P (1 + r)n.
This formula can then be used to express the present value, P, of an amount An that is
available n years in the future with a reinvestment rate, r, as:
P = An / (1 + r)n.
Although these formulas were developed on the basis of the cash flows occurring at the
end of their respective years, they apply just as well to flows that occur within years. For
example, the calculation of the present value of a cash flow that occurs after 2 years and 3
months would use the above formula with n=2.25.
Streams in perpetuity
There is one cash flow stream worthy of special considerationa stream of equal yearend cash flows continuing forever. Such a stream is called a perpetuity. At a reinvestment rate
of 15 percent, $20,000 will produce a cash flow stream of $3,000 per year forever. The $20,000
will not accumulate because the annual interest of $3,000 is taken out as a cash flow. By
definition, the present value of this perpetuity of $3,000 per year is the amount required today to
generate that never-ending stream. With a 15 percent rate, the stream can be generated with an
initial amount of $20,000, so the streams present value is $20,000. Note that the present value
is the annual payment divided by the rate ($3,000/.15). In general, a stream of equal annual cash
flows has a present value equal to the annual payment, C, divided by the reinvestment rate; this
is C/r. If investment A were a perpetuity with an annual payment of $22,000, one can see it
would have a present value at a reinvestment rate of 15 percent of $146,667 ($22,000/.15). One
can see the exponential effects of discounting from this figure because the present value of the
first three years of the perpetuity ($50,340) accounts for more than one-third of the present value
of the entire perpetuity.

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Pretax versus aftertax analyses

On some occasions, calculations can be simplified by working with pretax monetary
flows and avoiding tax calculations. Pretax analyses are appropriate when the pretax monetary
flows are proportional to their cash flows, which are always aftertax. This proportionality will
not be the case when the investments under consideration involve differences in depreciation,
investment tax incentives, or working capital. When these latter conditions exist, a doubling of
the pretax monetary flow will not result in a doubling of the cash flow.
When a pretax analysis is appropriate, at what reinvestment rate should the monetary
flows be discounted? It is tempting to think that a pretax reinvestment rate would be consistent
with the pretax nature of the flows, but this is incorrect. Because a full cash flow analysis will
always be appropriate, it is necessary to have any pretax (short-cut) analysis be consistent with it.
Tax considerations will affect the numerator of the present value calculation in a proportional
fashion (remember this was the condition necessary for a pretax analysis to be appropriate), but
an adjustment to the reinvestment rate will not affect the denominator in the same fashion. The
denominator of the present value calculation involves one plus the reinvestment rate and, as a
result, increasing the reinvestment rate proportional to the tax rate will not increase the
denominator proportionally. The non-proportional changes to the denominator will lead to an
inconsistency between the always correct cash flow analysis and the pretax analysis with a pretax
reinvestment rate.
As an illustration of the above discussion, suppose the tax rate is 50 percent, the
reinvestment rate is 10 percent, and a pretax monetary flow in year 1 is $100. The present value
of the cash flow associated with the monetary flow would be $45.45 ($100.50/1.10). The
correct pretax analysis would result in a present value of $90.90 ($100/1.10), which has the
pretax and the cash flow analyses in proportion to the tax rate. An incorrect pretax analysis
would be $83.33 ($100/1.20), which does not preserve the proportionality of the results. The
only meaningful reinvestment rate is the aftertax reinvestment rate, and it should be used in all
circumstances.

The Reinvestment Rate

Present value calculations require a reinvestment rate. Throughout this chapter, the rate
has been assumed to be known, but the methodology suggests the fundamental principle upon
which such a rate should be based. Cash that becomes available does not lie idle but is
recommitted to other activities throughout the firm. Strictly speaking, the appropriate rate is the
amount that must be earned on a dollar so the investor/manager is indifferent between receiving
the dollar now and receiving the dollar plus its earnings a year from now. Because the
estimation of this rate is difficult, the objective of this section is to provide a flavor, but not a
complete exposition, of approaches to the issue.

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Hurdle rate
One approach to the estimation of the reinvestment rate is to estimate the opportunity
rate, that is, the marginal rate of return of the pool of investment opportunities that the firm
might undertake with its available cash spinoffs. It was in this context that the 15 percent rate
was established for the assessment of investment A and investment B. In practice, where the
profile of potential investment opportunities is complex, the opportunity rate is a difficult
number to estimate.
An alternative approach is to seek the rate from the perspective of the companys cost of
capital. The prices that investors are willing to pay for a firms securities and the yields that
they demand from those securities determine a market cost of capital raised through debt and
equity. The cost of debt is simply the interest that must be paid, but because interest expenses
are tax deductible, the effective cost of debt is the aftertax interest rate. There is a corresponding
cost for shareholders equity because investors want to earn a satisfactory rate of return as
compensation for the use of their money and for the risks that they take by investing in the firm.
This cost applies both to the new investments made in the firm through the purchases of stock
and to the earnings that are retained in the firm rather than paid out in dividends. These costs,
combined with the capital structure of the firm, result in a weighted average cost of capital
(WACC). Because the WACC is the average rate demanded by the capital markets for
investment funds, the firm should consider only those investments whose cash flows will yield at
least that rate. Thus the value of the investment, from the perspective of the capital markets, is
the present value of the cash flows using the WACC.
In a perfect environment, where both the firm and the investors have complete
information, the WACC and the opportunity rate will be identical because the firm will invest in
all projects with a positive net present value at the weighted average cost of capital. As a result,
the marginal project will have a net present value equal to zero so its rate of return will be the
WACC. Even though the capital markets are not perfect, the WACC is commonly used as the
reinvestment rate. It is often referred to as the hurdle rate because investments with a positive
net present value at this rate are judged to be financially attractive; that is, to have passed the
hurdle. In contrast, investments with negative net present values fail the hurdle.

Internal Rate of Return

Frequently the accept/reject decision is not particularly sensitive to the exact value of
the hurdle rate and there may be a comfortable leeway for error in its specification. To find out
how much leeway there may be, the hurdle rate could be compared to the reinvestment rate, for
which the NPV of the investment is zero. At this break-even reinvestment rate the decision will

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change from accept to reject or from reject to accept. This break-even reinvestment rate is called
the internal rate of return (IRR).3
There is no formula for computing the internal rate of return; it must be found by trial and
error. For example, consider investment A. At a 15 percent reinvestment rate, the net present
value is $230. If the reinvestment rate were 10 percent, the investment would be even more
attractive and would have a net present value of $4,711. On the other hand, if the reinvestment
rate were increased to 17 percent, the net present value would be $1,389. As the reinvestment
rate changes from 10 percent to 17 percent, the net present value changes from being very
positive to very negative. Figure 1 is a graph of the relationship and shows that the net present
value is zero somewhere between 15 and 16 percent. Thus the internal rate of return is between
15 and 16 percent. By continuing a trial and error process, values in this range can be tested
until the reinvestment rate that results in a zero net present value is found. For investment A, the
internal rate of return is approximately 15.3 percent. If the reinvestment rate is less than 15.3
percent, the net present value will be positive and the investment will be judged to be attractive.
If the reinvestment rate is greater than 15.3 percent, the net present value will be negative. There
is little leeway between the reinvestment rate of 15 percent and the point where the investment
changes from attractive to unattractive, so a careful consideration of the appropriate reinvestment
rate is necessary.
In the accept/reject decision for an investment, the internal rate of return and the net
present value are equivalent. If an investments net present value at the reinvestment rate is
positive, the investments internal rate of return must be greater than the reinvestment rate. Refer
to Figure 1 for a visual confirmation of this statement. Similarly, if the internal rate of return is
greater than the reinvestment rate, the investments net present value at the reinvestment rate
must be positive. Regardless of the perspective, the investment is attractive, so the two figures
can be used interchangeably in this case.
Although net present value and internal rate of return are equivalent in the accept/reject
decision, internal rate of return should not be used to rank alternative, mutually exclusive
investments. The internal rate of return for an investment is calculated on the basis of the
investments stream of cash flows and is divorced from the actual reinvestment opportunities in
which the cash flows of the investment could be put. As its name states, the internal rate of
return is internal to the investment and does not reflect the reality of the reinvestment
environment facing the investor. As a result, internal rate of return does not apply a common
standard of comparison to each of the investments under consideration. Consequently, the
Selection of a project with a larger internal rate of return does not guarantee that it will have the
larger net present value at the appropriate reinvestment rate (rather than its own internal rate).

In certain circumstances there may be more than one reinvestment rate that results in a zero net present value
for an investment. Such cases may arise when the cash flow stream has more than one change in sign between
successive cash flows (that is, more than one time when successive cash flows change from negative to positive or
positive to negative). For these cases, the internal rate of return is not a useful concept.

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Figure 1
NPV of Investment A for Different Reinvestment Rates

To illustrate this point, consider the two investments whose net present values are graphed in
Figure 2. If a choice between these two alternatives is made on the basis of the larger internal
rate of return, Investment 1 would be selected. If the reinvestment rate is 15 percent, however,
Investment 2 is the better choice because it has the larger net present value at the actual
reinvestment rates available to the investor. Because of its inward-looking nature, the internal
rate of return can be a misleading criterion for selecting among mutually exclusive investments.
Figure 2
NPV and IRR

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Nominal versus effective rates of return

Suppose an annual reinvestment rate is quoted as 12 percent. Does this mean each dollar
invested will earn one cent at the end of the first month? It all depends on whether the annual
rate is being quoted as an effective annual rate or a nominal annual rate and on how frequently
earnings are compounded. There is considerable room for confusion unless terms and
assumptions are carefully specified.
Let us suppose that a 12 percent annual rate results in a 1 percent payment each month.
Because of the compounding of the monthly payments (interest being earned on interest), the
year-end value of an investment will be more than 112 percent of the initial investment. A
$1,000 investment would have a year-end value of
$1,127 = $1,000 1.01 1.01 1.01 . . . 1.01 = $1,000 (1.01)12.
This is equivalent to a 12.7 percent annual rate, even though a 12 percent annual rate was quoted.
A vocabulary that would clarify the situation is to state that the nominal annual rate is 12 percent
compounded monthly and the effective annual rate is 12.7 percent. Reinvestment rates are
quoted as effective annual rates.
Not only is it important to distinguish between nominal and effective annual rates, but
also care must be taken when stating equivalent rates for periods of less than a year. For a 12
percent nominal annual rate that is compounded monthly, the equivalent monthly rate is 1
percent (the annual rate divided by 12). For an effective annual rate of 12 percent, the monthly
rate must be calculated taking into account the compounding during the year.
If the effective annual rate is 12 percent, the value of a dollar at the end of the year is $1.12. If
returns are made on a monthly basis, the monthly rate must satisfy the following equation:
$1.12 = $1.00 (1 + monthly rate)12.
The solution of this equation is a monthly rate of .95 percent (.0095). Note that because of the
compounding that is inherent in effective rates, the equivalent monthly rate for an effective
annual rate is less than the equivalent monthly rate for a nominal annual rate. In general, the
equivalent periodic rate of an effective annual rate is
(1 + effective annual rate)1/number of periods 1.