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Good day.
How do you go about choosing which % to use when calculating IIR? Is it a random guess?
Good Day
Scenario: BB has some 5% loan notes in issue, which are redeemable in 3 years time at a premium of 12.5%. The current market value of the loan notes is $98.Using discount rates of 5% and 10% calculate YTM.
Question: I am trying to understand why the $98 is seen as an outflow (-) and the payment of $5 for 3 years and premium of $112.5 is seen as inflows (+) as per the answer provided?
As it’s an “issue” it is a liability which means we make the payment of 5 and 112.5 which are outflows (-)?
Is my understanding correct or am I missing something?
Hi Darryn,
No, your not missing anything as the issue is an inflow, however to make life easier with the IRR we reverse all of the cash flows. Why?
A normal project under IRR is an initial outflow and then a series of inflows. When we’ve done this and used 5% to calculate the NPV, if this gave us a positive number then we’d increase the discount rate to 10% in the hope the NPV is then negative. By switching the cash flows then we remain consistent with what we’ve done previously.
If we left it the way the cash flows are, i.e. and inflow followed by a series of outflows, then if we started with 5% and it was negative we would then use 10% only to then find that it would be even more positive than the estimate at 5%.
It’s a bit confusing but there is method in the madness.
Thanks
Formula
i + 1/n (RV-NP) / 1/2 (RV+NP)
i= coupon rate
n= yrs
RV= redeemable value
NP= issue value
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