- May 27, 2019 at 3:12 am
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.
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
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.May 27, 2019 at 8:46 am
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.May 27, 2019 at 9:46 am
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.
KennethMay 27, 2019 at 11:02 am
Interest 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.October 19, 2019 at 3:17 pm
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.October 21, 2019 at 7:53 am
As I said in my reply above, I think this whole question is messed up. It makes no sense to me.
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