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Capital Budgeting Part Two (HP10BII) -- Calculating Internal Rate of Return - YouTube
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In this video we're going to use the
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HP10BII financial calculator
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in order to walk through a couple of
internal rate of return examples for
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capital budgeting
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this is a continuation of our capital
budgeting video series. In the first
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video
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we looked at calculating pay-back period.
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In this video we do internal rate of return.
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So we have two sets of capital budgeting
projects -- projects A and B.
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Project A has an initial cash outflow
two hundred thousand
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than one hundred twenty thousand, ninety
thousand, fifty thousand, forty thousand,
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and thirty thousand
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Its got a five year time horizon
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and a required return of twelve percent
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Its also got a critical acceptance level of 2.75 years
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which we're not going to be using in this
example
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but is used when we calculated payback period.
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So again we're going to be doing the
internal rate of return on the
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HP10BII financial calculator
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and the first thing we want to do after
turn our calculator on
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is go-ahead and do the
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shift
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clear all -- make sure we clear it out. So
shift
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clear all.
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Make sure your character is setup to one
period per year.
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With the HP10BII financial calculator
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the periods per year for the five key
is the same as the periods per year for your
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cash flow worksheet so if you've been
doing something else, maybe your calculator
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was set for semi-annual for a bond
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or monthly for a mortgage payment
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and you don't change that to one period per
year
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its going to mess up your internal rate of
return calculation.
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So make sure that its set at one period per
year,
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cleared out,
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and now we're ready to start inputting the
values.
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We want to start with our initial
investment of two hundred thousand
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dollars.
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It's two hundred thousand
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and make sure that it's negative. Use
that +/- key,
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change it to negative.
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This is one of the common mistakes that I
see a lot of students make when they're
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doing internal rate of return and net
present value calculations
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is that they forget to setup that initial
cash flow as negative.
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If you're trying to solve for the
internal rate of return and that initial cash
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flow is not negative,
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its going to give you no solution because it
can't figure out how you're going to
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make money
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without ever giving anything up.
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A rate of return is based on an
investment that then generates cash
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flows later on so you've gotta make that
negative
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or you're going to get no solution
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so got that two hundred thousand
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press the cash flow button.
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Now we go to our next cash flow,
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one hundred twenty thousand
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Again we want to press that cash flow button put
that one in
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Now notice that these cash flows are all
independent. We don't have a hundred
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twenty thousand, a hundred twenty
thousand, a hundred twenty thousand. We just
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have each cashflow one time.
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Now the default frequency -- our Nj --
on this calculator
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is one so we don't have to tell it it's
one in already assumes that unless we tell
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otherwise.
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If we would have had a hundred twenty
thousand, a hundred twenty thousand, a
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hundred twenty thousand
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we woud want to tell it frequency (or Nj) three
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But since it's just one
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we don't have to pay attention
to the Nj
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So go to our next cashflow, ninety
thousand
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and CFj
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Next cashflow -- fifty thousand
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and CFj
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Next cash flow
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forty thousand
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CFj
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Last cashflow -- thirty thousand
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CFj
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All our cash flows are entered now
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so now all we have to do is solve for
the internal rate of return per year.
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Notice that that's a shift function. It's our orange shift
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so we have to
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shift
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internal rate of return
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and it takes a second thinking then kicks out our answer -- 26.72
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and remember that's percent. Internal rate of
return is the rate of return
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Its our expected
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rate of return off of our two hundred
thousand dollars initial investment
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over the five-year time period.
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so let's go ahead and write that down
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26.72%
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And now we want to do Project B.
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Again, make sure the first thing you do is
clear out the worksheet otherwise you're
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just gonna be adding to these cash flows
that are already there
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So, shift
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clear all
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clears that out
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now we're ready to start putting in our cash
flows -- negative four hundred thousand
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So four hundred thousand
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+/- key to make it negative
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CFj put that in
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and again all these are just one time
period
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so we can just ignore the Nj
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So our next cash flow is forty thousand
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CFj
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and we've got a sixty thousand dollar cash
flow
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one hundred twenty thousand dollar cash
flow
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Oops now see I went a little too far here and
put in one point two million
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I haven't pressed CFj
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but instead of clearing it all out all
have to do is see this back arrow button?
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Press that and it takes away my last zero. It's
back to the hundred twenty thousand I
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want
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and press CFj
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two hundred forty thousand
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CFj
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and three hundred forty thousand
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CFj
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now all my cash flows are entered
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Again I want to solve for that internal
rate of return per year
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Its a shift function
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So shift
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internal rate of turn
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gives me 19.74%
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Now a quick interpretation -- what do I do
if the projects are independent?
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If they are independent, based solely on
internal rate of return,
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I can choose A
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or I can choose B
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or I can choose both
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or neither one.
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I'll remember my internal rate of
return is the expected rate of return
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the k (or hurdle rate)
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is my required return
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Since my expected return exceeds my
required return for
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both of these projects,
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and they're independent, I want to take
them both.
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Both of them are going to have an
average annualized expected return over
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the next five years
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that's greater than my required returns so they
are both good projects.
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How about if they are mutually exclusive?
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With mutually exclusive remember its not
enough to choose whether or not the
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project is good
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I have to choose the best.
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If I take A
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I can no longer take B.
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If I take B
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I can no longer take A.
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So I've got to decide which is best
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According to internal rate of return, the
higher the internal rate of return the
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better
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so project A is the best. If these are
mutually exclusive
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according to internal rate of return
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I would wanted to take Project A.
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That should help you with calculating
internal rate of return
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using your HP10BII financial
calculator.
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