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Q) present value of cash flows are calculated at 10% of interest. NPV is + on 10% and — at 15% of interest. IRR is at 11.75% my teacher says 10% is your required return and 1.75 is your MARGIN OF SAFETY. the greater the margin of safety the less risky the project will be. MARGIN OF SAFETY point is not clear. please explain it.
Your teacher is correct.
The IRR is 11.75% and therefore at a rate of interest of 11.75% the NPV would be zero.
If the rate of interest is less than 11.75% then the NPV will be positive and we should accept the investment, but if the rate of interest is more than 11.75% then the NPV will be negative and we should reject the project.
We think that our rate of interest is 10% and so we will accept the project. However in real life it is impossible to calculate the rate of interest precisely (for all sorts of reasons that we look at in Paper F9). It could be that the rate of interest turns out to be 11% or 12% or anything!
Provided it does not go above 11.75% then we are still OK to accept the project.
So……we are OK provided the rate of interest does not change by more than 1.75% (11.75 – 10). This is our margin of safety.
Although it may turn out that the rate of interest is different from 10% – there is always a risk of that happening. The bigger the change, the less likely it is to happen.
(OK – it may change to 20% in theory but it is very unlikely that it would change so much)So the bigger the change we can accept (the margin of safety) the less risk there is of it changing by so much.
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