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- This topic has 5 replies, 3 voices, and was last updated 8 months, 2 weeks ago by Ken Garrett.

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- May 27, 2019 at 3:12 am

hkkwuParticipantHi 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.May 27, 2019 at 8:46 am

Ken GarrettKeymasterIt 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

hkkwuParticipantThank 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,

KennethMay 27, 2019 at 11:02 am

Ken GarrettKeymasterInterest 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

dsodhaParticipantReferring 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

Ken GarrettKeymasterAs I said in my reply above, I think this whole question is messed up. It makes no sense to me.

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