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Hi tutor,
I am confused by the answer to Q256. Why would be discount rate reduced by 1.25% the NPV would fall to zero? I thought it should be the rise in discount rate, which would make the NPV fall.
Thanks,
StudentQuestion:
Q Co is going to invest in a new piece of machinery that will cost $8,000,000. The discount
rate of the project is 15% and the PV of the tax shield is $100,000.
What is the IRR? Give your answer as a % to 2 decimal places
_____________%Answer:
256 14.81
The IRR is the discount rate where the NPV falls to zero.
It is a really a sensitivity calculation, the questions we need to ask ourselves are as follows:
(1) How much would the NPV need to change by? 100,000
(2) What is this as a % of the investment? 100,000/8,000,000 × 100 = 1.25%
So if the discount rate reduced by 1.25% the NPV would fall to zero.
IRR = 15% × 98.75% = 14.8125
Answer: 14.81.It confuses me too.
The tax shield is present value of tax relief on debt interest payments evaluated at the pre-tax cost of debt and is used in APV calculations. We are not told the NPV of the project at 15%, nor its APV (though that would be $100,000 higher than the NPV).
The NPV could be $20,000,000 – we don’t know and the IRR of that project would be very high indeed!
I think the whole question is messed up.
Thank you Ken.
I still have P3 and F3 remaining, but I found both are very technical in context.
I found it very difficult to understand the interest rate risk and exchange rate risks chapters.
Would you have any recommendations? I really wish to complete the strategic level before the change of syllabus.
thanks,
KennethInterest rate risk is tricky. Have you looked at our notes and lectures? I think that once you grasp that the price of an interest rate future is:
100 – interest rate
you can make a fair stab at working out, what to do using logic. However, I must confess that even after teaching this material for years I still find that I can mess up!
Remember that there are unlikely to be more than a couple of OT questions in teh exam on this topic.
Referring to the IRR question above.
Please help me understand why the IRR is lower and not higher than the cost of capital by 1.25%.
Surely to lower the NPV from 100 000 to 0 we have to increase the discount rate so that the PV of the cash flows reduce to make NPV 0.
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