Calculating the internal rate of return (or IRR) of a project is one of the most popular methods that companies and managers use to determine whether a project is worth investing in. Now that I’ve covered a bit about NPVs and DCFs, it makes sense to go through what IRR is, how to use it, and why it’s not an ideal measurement.

When using NPV to determine whether or not to invest in a project, the general rule is to accept the project if NPV > 0 and reject if NPV is negative (or zero).

But since NPV results in a dollar figure, some managers have a hard time conceptualizing what that number (the present value of future cash flows) really represents. Instead, they prefer to look at percentages, and that’s where IRR comes in.

IRR is the rate at which the project NPV equals 0. It also provides the expected return rate of the project, assuming certain conditions are met. In other words, if C(n) is the cash flow for each period, then

and you’d find IRR by setting NPV = 0 and solving for “r” above. (Excel’s IRR function makes this all a cinch by running an iterations.)

Let’s look back at Experiment in Finance’s NPV calculation as an example.

I noted in my previous entry that this site’s NPV through July was $89.93. Here are the cash flows again:

Read the rest of this entry »

I’ve been meaning to write a bit about NPV after having discussed how to calculate discounted cash flows and using NPV to calculate the valuation of this site. Since I haven’t written about corpoate finance in a while, I thought this might be a good change of pace.

When we calculate DCFs, what we’re essentially trying to do is calculate the value of all the future cash flows at a given point in time, most often at the present moment. As discussed earlier, to do this, you need to know or forecast future cash flows in each period as well as have a discount rate in mind that reflects the riskiness of the project or events leading to the cash flows.

One way to determine whether a project is worth accepting or not is to look at its net present value (NPV). At a high level, NPVs are very much like DCFs. NPVs involve comparing the present value of cash inflows with cash outflows, and calculating each one can get complicated depending on how a company is set up (leveraged or unleveraged) because deciding what to include or exclude and their interactions with tax can get hairy. So, to simplify this discussion on IRR, I’ll use Experiments in Finance’s NPV calculations to demonstrate.

Read the rest of this entry »

I’m not big into business or finance books. In my opinion, you can learn more about human nature, leadership, and management through reading time-proven literary classics than whatever’s currently on the non-fiction best sellers list. If I find a book worth reading, chances are it teaches a specific skill (like how to prepare for the GMAT) or it’s a book I’ve kept on my shelf because it’s worth multiple re-reads.

The book I’m recommending today does both of the above. I first purchased it as part of a class on negotiation while at Michigan in bschool, a class that turned out to be one of my favorites. (Note to anyone who might be contemplating business school: your best classes often turn out to be taught by real-world practitioners, not the ones with PhDs from elite schools!)

Before I ever took a class, I’d always envisioned negotiation the way Hollywood has taught us it works: two powerful guys or groups, all dressed in suits, sitting across the long table from each other playing hardball and sniffing out weaknesses in the other party. If this was what it took to succeed, I decided I might as well forget it. Neither my personality nor the way I was raised easily lent itself to this sort of fight.

The reason I liked Bargaining for Advantage is that it taught me that successful negotiation didn’t have to resort to such tactics. Sure, some people do, but if they succeed, it’s because that’s their strength. Besides, such a tactic doesn’t always work.

Read the rest of this entry »

Reverse auctions (also known as procurement auctions) are a type of auction commonly used in business-to-business transactions. Instead of a seller trying to fetch the highest price for his item from bidders, there’s a buyer who attempts to get the lowest bid possible from sellers.

Picture this: you work for a company that sells dog collars but who has decided to outsource manufacturing instead of making them in-house. You send out a design spec — sizes, materials, maybe colors — and in return, you receive quotes from suppliers. Your suppliers naturally want to make a profit too, so they start out their quotes on the high end, and if you were to negotiate with them one-by-one, it would take a long time, and you’d have less leverage to use against them.

Read the rest of this entry »

Ah, those wacky Brits. We have Dilbert, they have Alex.

Yes, over in London, they actually have a popular comic strip that makes fun of investment banking and all the crazy values and culture that surrounds working in the world of international finance. It’s been going strong since the late 80s, but unfortunately, Alex isn’t easily found over on this side of the pond: it’s not even available through Amazon.

I dunno. You think if the world of high finance and i-banking were more integrated into US daily life like this that people would be less afraid of it and kids would be more aspired to learn about it?