HP 12C Tutorial
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In the previous section we looked at the basic time value of money keys and how to use them to calculate present and future value of lump sums and annuities. In this section we will take a look at how to use the HP 12C to calculate the present and future values of uneven cash flow streams. We will also see how to calculate net present value (NPV), internal rate of return (IRR), and the modified internal rate of return (MIRR).
In addition to the previously mentioned financial keys, the 12C also has keys labeled CF0 and CFj (the cash flow keys) to handle a series of uneven cash flows.
Suppose that you are offered an investment which will pay the following cash flows at the end of each of the next five years:
How much would you be willing to pay for this investment if your required rate of return is 12% per year?
We could solve this problem by finding the present value of each of these cash flows individually and then summing the results. However, that is the hard way. Instead, we'll use the cash flow keys. All we need to do is enter the cash flows exactly as shown in the table. Again, we must clear the cash flow registers first. In this case we need to press f X><Y. Now, enter the time period 0 cash flow into CF0 and the remaining cash flows into CFj. To enter the cash flows, simply press g then the appropriate key (either PV or PMT). We must also enter the interest rate into i. To get the present value of the cash flows press f PV (you'll see that the shifted version of PV is NPV). We find that the present value is $1,000.17922. Note that you can easily change the interest rate by simply entering a different rate into i and the solving for NPV again.
Now suppose that we wanted to find the future value of these cash flows instead of the present value. There is no key to do this so we need to use a little ingenuity. Realize that one way to find the future value of any set of cash flows is to first find the present value. Next, find the future value of that present value and you have your solution. In this case, we've already determined that the present value is $1,000.17922. Clear the financial keys (f X><Y) and then enter -1000.17922 into PV. N is 5 and i is 12. Now press FV and you'll see that the future value is $1,762.65753. Pretty easy, huh? (Ok, at least its easier than adding up the future values of each of the individual cash flows.)
Calculating the net present value (NPV) and/or internal rate of return (IRR) is virtually identical to finding the present value of an uneven cash flow stream as we did in Example 3, except that we must also enter the initial outlay.
Suppose that you were offered the investment in Example 3 at a cost of $800. What is the NPV? IRR?
To solve this problem we must not only tell the calculator about the annual cash flows, but also the cost (previously, we set the cost to 0 because we just wanted the present value of the cash flows). Generally speaking, you'll pay for an investment before you can receive its benefits so the cost (initial outlay) is said to occur at time period 0 (i.e., today). To find the NPV or IRR, first clear the cash flow registers and then enter -800 into CF0, then enter the remaining cash flows exactly as before. For the NPV we must supply a discount rate, so enter 12 into i, and then press f PV. You'll find that the NPV is $200.17922.
Solving for the IRR is done exactly the same way, except that the discount rate is not necessary. This time, you'll press f FV to find that the IRR is 19.5382%.
The IRR has been a popular metric for evaluating investments for many years — primarily due to the simplicity with which it can be interpreted. However, the IRR suffers from a couple of serious flaws. The most important flaw is that it implicitly assumes that the cash flows will be reinvested for the life of the project at a rate that equals the IRR. A good project may have an IRR that is considerably greater than any reasonable reinvestment assumption. Therefore, the IRR can be misleadingly high at times.
The modified internal rate of return (MIRR) solves this problem by using an explicit reinvestment rate. Unfortunately, financial calculators don't have an MIRR key like they have an IRR key. That means that we have to use a little ingenuity to calculate the MIRR. Fortunately, it isn't difficult. Here are the steps in the algorithm that we will use:
- Calculate the total present value of each of the cash flows, starting from period 1 (leave out the initial outlay). Use the calculator's NPV function just like we did in Example 3, above. Use the reinvestment rate as your discount rate to find the present value.
- Calculate the future value as of the end of the project life of the present value from step 1. The interest rate that you will use to find the future value is the reinvestment rate.
- Finally, find the discount rate that equates the initial cost of the investment with the future value of the cash flows. This discount rate is the MIRR, and it can be interpreted as the compound average annual rate of return that you will earn on an investment if you reinvest the cash flows at the reinvestment rate.
Suppose that you were offered the investment in Example 3 at a cost of $800. What is the MIRR if the reinvestment rate is 10% per year?
Let's go through our algorithm step-by-step:
- The present value of the cash flows can be found as in Example 3, but this time we are using the reinvestment rate to discount the cash flows. Clear the TVM keys and then enter the cash flows (remember that we are ignoring the cost of the investment at this point): press f X><Y to clear the cash flow keys. Now, press 0 then CF0, 100 CFj, 200 CFj, 300 CFj, 400 CFj, and finally 500 CFj. Now, enter 10 into the i key and then press f PV. We find that the present value is $1,065.26.
- To find the future value of the cash flows, enter -1,065.26 into PV, 5 into N, and 10 into i. Now press FV and see that the future value is $1,715.61.
- At this point our problem has been transformed into an $800 investment with a lump sum cash flow of $1,715.61 at period 5. The MIRR is the discount rate (i) that equates these two numbers. Enter -800 into PV and then press i. The MIRR is 16.48% per year.
So, we have determined that our project is acceptable at a cost of $800. It has a positive NPV, the IRR is greater than our 12% required return, and the MIRR is also greater than our 12% required return.
Please continue on to the next page to learn how to solve problems involving non-annual periods.