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Dear F9 tutor,
The most difficult job for me in F9 is choosing the discount rate while doing IRR, I usually take within 5 number difference with cost of capital but sometimes both of the NPV come out negative! Or if sometimes get the IRR rate then it appears far away from the actual ans. Please let me know the trick behind choosing an appropriate discount rate for IRR.It does not matter which two guesses you make. The answer will be slightly different (because it is not a linear relationship) but if it is more than 1% different then it means you have made a mistake in your arithmetic.
There is no special trick.
If part (a) of the question asks for an NPV at a specific cost of capital, then that is your first ‘guess’. Otherwise I always use 10% as my first guess.
For the second guess, again any rate will do just so long as it is sensible.
If your first guess is 10% and the NPV is positive, then the second guess should be at a higher rate (I use either 15% or 20%).
If you first guess is 10% and the NPV is negative, then the second guess should be at a lower rate (I use 5%).If both NPV’s end up negative or positive (which will not usually happen if you follow the above) then you can still calculate the IRR in the normal way – you do not need to make a third guess!
I don’t know how you go about the calculations – there are several ways of doing it (which obviously all give the same answer). Some people learn a formula, but I hate that!!
It may help you to watch my free lecture on this if you are always getting answers that are a lot different.
Thank you very much, Sir. I didn’t know this before and I use this formula,
Lower rate+ (Higher rate – Lower rate)/(Lower rate NPV – Higher rate NPV) x Lower rate NPV.
My ans. comes out totally different from the real ans. I’ll try that rule next time.Yes, just have solved one question. The NPV came out positive with the first rate so took a higher rate than that for IRR, NPV was negative this time and ans. was exactly the same of the kit ans., for the first time! Thank you once again!
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