330 Part III: Financial Formulas

Figure 12-13: Using the IRR function to calculate geometric average growth.

Checking results
Figure 12-14 shows a worksheet that demonstrates the relationship between IRR, NPV, and PV by
verifying the results of some calculations. This verification is based on the definition of IRR: The
rate at which the sum of positive and negative discounted flows is 0.

Figure 12-14: Checking IRR and NPV using sum of PV approach.

The NPV is calculated in cell B16:

=NPV(D3,B7:B14)+B6

The internal rate of return is calculated in cell B17:

=IRR(B6:B14,–90%)

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In column C, formulas calculate the present value. They use the IRR (calculated in cell B17) as the
discount rate, and use the period number (in column A) for the nper. For example, the formula in
cell C6 is

=PV($B$17,A6,0,–B6)

The sum of the values in column C is 0, which verifies that the IRR calculation is accurate.
The formulas in column D use the discount rate (in cell D3) to calculate the present values. For
example, the formula in cell D6 is

=PV($D$3,A6,0,–B6)

The sum of the values in column D is equal to the NPV.

For serious applications of NPV and IRR functions, it is an excellent idea to use this type of
cross-checking.

Multiple Rates of IRR and the MIRR Function

In standard cash flows, there is only one sign change: from negative to positive, or from positive
to negative. However, there are cash flows in which the sign can change more than once. In those
cases, it is possible that more than one IRR can exist.

Multiple IRRs
Figure 12-15 shows an example that has two IRR calculations, each of which uses a different
“seed” value for the guess argument. As you can see, the formula produces different results.

Figure 12-15: The same cash flows can have multiple IRRs.

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 332 Part III: Financial Formulas

You can find the workbook with all of the examples in this section, multiple irr.
xlsx, on the companion CD-ROM.

The IRR formula in cell B21 (which returns a result of 13.88%) is

=IRR(B7:B16,B3)

The IRR formula in cell B22 (which returns a result of 7.04%) is

=IRR(B7:B16,B4)

So which rate is correct? Unfortunately, both are correct. Figure 12-15 shows the interest and run-
ning balance calculations for both of these IRR calculations. Both show that the investor can pay
and receive either rate of interest, and can secure a (definitional) final balance of $0. Interestingly,
the total interest received ($1,875) is also the same.
But there’s a flaw. This example illustrates a worst-case scenario of the practical fallacy of many
IRR calculations. NPV and IRR analyses make two assumptions:

h You can actually get the assumed (for NPV) or calculated (for IRR) interest on the out-
standing balance.
h Interest does not vary according to whether the running balance is positive or negative.

The first assumption may or may not be correct. It’s possible that balances could be reinvested.
However, in forward-projections in times of changing interest rates, this might not be the case.
The real problem is with the second assumption. Banks simply do not charge the same rate for
borrowing that they pay for deposits.

Separating flows
The MIRR function attempts to resolve this multiple rate of return problem. The example in this
section demonstrates the use of the MIRR function.
Figure 12-16 shows a worksheet that uses the same data as in the previous example. Rates are
provided for borrowing (cell B3) and for deposits (cell B4). These are used as arguments for the
MIRR function (cell B19), and the result is 6.1279%:

=MIRR(B7:B16,B3,B4)

The MIRR function works by separating negative and positive flows, and discounting them at the
appropriate rate — the finance rate for negative flows and the deposit rate for positive flows.

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 Chapter 12: Discounting and Depreciation Formulas 333

Figure 12-16: Multiple internal rates of return.

You can replicate the MIRR algorithm by setting up a revised flow, which compares the two NPVs
(refer to Figure 12-16, columns C:E). The negative flow NPV is placed at period 0, and the positive
flow is expressed as its equivalent future value (by accumulating it at the deposit rate) at the end
of the investment term. The IRR of the revised flow is the same as the MIRR of the original
(source) flow.
This example reveals that the methodology is suspect. In separating negative and positive flows,
the MIRR implies that interest is charged on flows. Banks, of course, charge interest on balances.
An attempt at resolving the problem is shown in the next example.

Using balances instead of flows

The MIRR function uses two rates: one for negative flows and one for positive flows. In reality,
interest rates are charged on balances and not on flows. The example in this section applies dif-
ferent rates on negative and positive balances. The interest calculation uses an IF function to
determine which rate to use.
When analyzing a project in which interest is paid and received, the end balance must be zero. If it
is greater than zero, you have actually received more than the stated deposit rate. If it is less than
zero, you still owe money, and the finance rate has been underestimated. This example assumes a
fixed finance rate and calculates the deposit rate needed to secure a zero final balance.
In the Risk Rate Equivalent IRR method, the finance rate is fixed (at 9% in this example). The
interest received on positive balances is found by using the Data➜Data Tools➜What-If
Analysis➜Goal Seek command. In this example (see Figure 12-17), cell D21 was set to zero by
changing cell C6.

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 334 Part III: Financial Formulas

Figure 12-17: Accumulating balance approach for multiple IRRs.

The series of flows then becomes the change in the balances, rather than the original given cash
flows. The internal rate of return on these balanced-derived flows is zero, or very close to zero.
I’ve already taken into account all the financing and reinvesting necessary for the project, and the
resulting interest and return are shown in the flows. The Risk Rate Equivalent IRR may be com-
pared with a different rate such as the Risk Free Rate of Return (traditionally 90-day Treasury
bills) to determine the relative risk of the project.
But what does this all mean? If you pay 9% on negative balances, this project returns an 8.579%
rate to you on positive balances. The name “Risk Rate Equivalent IRR” refers to the fact that it
determines how the project compares with the return on money invested in a bank or 90-day
Treasury bills.
There is no requirement that the finance rate be fixed. A bank may do calculations in the same way
but fix the deposit rate and allow the Goal Seek feature to calculate the equivalent lending rate.

Irregular Cash Flows

All the functions discussed so far — NPV, IRR, and MIRR — deal with cash flows that are regular.
That is, they occur monthly, quarterly, yearly, or at some other periodic interval. Excel provides
two functions for dealing with cash flows that don’t occur regularly: XNPV and XIRR.

Net present value

The syntax for XNPV is

XNPV(rate,values,dates)

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