Investment Appraisal Discounted Cash Flow – Internal Rate of Return (example 3)

ACCA F9 lectures ACCA F9 notes


Comments

  1. avatar says

    Dear John,
    Can you please let me know the brief meanings for “cost of capital”? I have searched on net but they are not giving a good brief understanding

    Though I am aware of concept but I cant make proper meanings of it.

    Many Thanks

    • Profile photo of John Moffat says

      It is the cost to the company of their long-term finance – effectively the interest that they are having to pay on their borrowings.

      The long term finance borrowed from debt lenders will involve paying interest.
      The long-term finance raised from shareholders does not involve paying interest, but shareholders will be requiring dividends and that is effectively like paying interest.

      (You have posted this under a lecture on internal rate of return, but there is no direct connection. You should watch my introductory F9 lecture and also my lectures on Cost of Capital itself.)

      • avatar says

        I am grateful to you for coming to my confusion and being so quick. I do apologize for the mistake.

        Many Thanks

  2. avatar says

    Dear sir,

    Technically IRR is the rate at which NPV becomes zero. So if the current COC used to appraise the project is more than IRR means NPV will become negative which will lead to rejection. At the same time a current COC used for the appraisal below IRR will give a positive NPV which will lead to acceptance. So if the current return rate is more than IRR means should we reject the project. Please correct me if i am wrong.

    • Profile photo of John Moffat says

      Yes – the definition of the IRR is that it is the rate of interest at which the NPV is zero.

      What you have written is correct (although your next to the last sentence says ‘the current return rate…..’. You mean ‘the current cost of capital….’ (But you already said that earlier :-) )

  3. Profile photo of hamzaharoon says

    Thanks Sir Its a Great Lecture, However I was confused at the part where you instead of subtracting a Positive and Negative NPV you added them, but in the end of the lecture in different example You Subtracted Both Positive NPVs to get IRR, is this a trick or a formula? Anyways thanks sir :)

      • Profile photo of hamzaharoon says

        I Remember When I was in school and when I was taught Algebric Division, The Sign of the Second number was changed whenever we try to add or subtract For E.g we wrote +20 and below it +15 but in algebric division rule we change the sign of second number i.e now it is -15 so we subtract 15 from 20, Similarly in Vice Versa +25 is written and below -10 so we change the sign of second number i.e +10 so we added both 25 + 10. hmm now I think I Understood,its the same rule which applies here Thank you Sir :)

  4. avatar says

    Dear john
    I was practicing opentution practice math number 7 OPERA LTD,here I have a few questions as follows:

    1.while doing part a why have not we calculated the average rate of return for current year?we calculated it normally and then we compared with the forecasted average rate of return.should not we calculate the average rate of return for current year and then compare it with the average return of the project proposed?i mean why not both are average rate?

    2.why did not we include the 2m scrap value while calculating capital employed.should not it be included in the final year as a cash inflow?or it has something to do it with depreciation??pls make my understanding clear on this matter.

    3.why did not we calculated the t0?we started from year 1,but should not we been make the initial capital employed at the t0 and then the first addition in the year 1?
    4.while calculating the average capital why did not we follow the formula that is initial capital+scrap / 2.?

    my questions could have been silly but Im really looking forward to have a reply from you to make my understanding clear.
    Thanks in advance.

    • Profile photo of John Moffat says

      Sorry to be a nuisance , but please can you copy and paste this question to the Ask the Tutor forum.

      (The reason is that I do not have time to answer now and it will disappear from the list. I will answer when I get back from work)

  5. avatar says

    Dear John

    Thanks you for the lecture.. I practised the June 2009 paper question 2. Im getting an IRR of 14,22% at a DF of 15%. The answer is giving a IRR of 18.22% when they discount at 20%. Does this mean my answer is wrong? there is a difference of 4% in the IRR.

    Thanks you

    • Profile photo of John Moffat says

      Your answer is wrong :-(

      If you discount at 15% the NPV is +126,931 and so the IRR must be higher than 15%.

      We already know that at 10% the NPV is +366,722.

      And so over a change of 5 percentages, the NPV falls from +366,722 to +126,931 which is a fall of 239,791

      Starting from 15% we need the NPV to fall by 126,931 to get to zero, and so the IRR = 15% + (126931/239791 x 5%)

      This comes to an IRR of 17.65%. (It is still a bit different from the examiners answer but the difference is small and is because it is not a linear relationship. This would still get full marks.)

    • Profile photo of John Moffat says

      Finding the IRR always involved making two guesses and then approximating between them – as I have done in this lecture. You can write what I have done as a formula but there is not much point since it doesn’t make it any easier or faster and you are not given a formula for it on the formula sheet. Also, since the whole point of the exam is to make sure you understand what you are doing, it seems rather silly to learn a formula that does not speed things up just for the sake of it.

  6. avatar says

    Now this is what I call training future Finance Managers not just some of the stuff that other providers give where you are just told learn this formulae withouth a full understanding. This is top class qaulity thank you Mr Moffat and God bless everyone at Open tuition may you continue to be a sucess.

  7. avatar says

    Dear Sir, I read a book saying that “accept the project if the IRR is higher than the cost of capital”. I bit confuesed with this sentence.Your lecture note saying that, eg, if at 10% COC +’ve NVP6,660 & If IRR let say at 13% it will be break even. If to accept the project with higher IRR, Is that mean it’s beyond 13%….Pls advice..

    • Profile photo of John Moffat says

      @sharman, You misunderstood. If the cost of capital = 13% (the IRR) then the project will break-even (i.e. the NPV will be zero).

      If the cost of capital is less than 13% then the NPV will be positive and the project should be accepted. If the cost of capital is more than 13% then the NPV will be negative and the project should be rejected.

Leave a Reply