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Hey John,
I’m in a bit of a pickle over the amount to be entered in time 0 while calculating IRR
My perspective is that the cash flows for irr must be the actual cash flows that has/ would take place so the initial amount of say, a loan would be the amount at which it was issued but the formula requires you to use mv of the loan notes.
I’ve watched the lectures and gone through other similar queries in the forum but i can’t for the life of me get my head around your response.
This is my understanding of the whole ordeal: do we mayhaps use the mv because in a situation where we’re assessing a prospective debt arrangement, if we were to borrow, then we would do so at the current mv? If this is right then what about questions where the loan notes are already in issue and we’ve got to compute the wacc, hasn’t the initial inflow already occured in the past ?Thank you.
When calculating the cost of debt we always use the current market value of the debt. This is because the MV Is determined by the investors and depends on the rate of return that they are currently requiring.
It is not because new debt will be issued at the MV of the existing debt. It is because if the investors are requiring a return of (say) 6% on the existing debt (using the current MV to calculate it), then if we are raising new debt the company is going to have to give them a return of 6% otherwise nobody is going to lend them the money.
When calculating the WACC we always use the total MV of the existing debt. Although the amount initially borrowed might have been more or less than the current MV, the current level of borrowing is the current MV (if the company were to buy all the debt in issue on the stock exchange and then cancel it, they would have to pay the current MV to do it. Obviously they are not going to do that, but it is the current MV that represents the current level of the borrowing.)
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