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After reading the ans, I still don’t understand and got some questions:
Q1
why 0.75 is used in the calculation of discounted revenue cash flows? is it 1- Tax rate?Q2
The ans shows:
Reduction in selling price = 7,801/ 43,441 = 18%.Why is such calculation used to get the ‘Reduction in selling price’.
Would you explain the reason behind it?Thanks
1. Yes – it is 1 – tax rate (because if the revenue falls, then the profits fall by the same amount, and therefore the tax payable falls by 25% of the fall in revenue).
2. Imagine the revenue was to fall by 10% each year (and everything else stays the same). Then the PV of the revenue flows would also fall by 10%, and therefore the NPV would fall by the same amount.
Here, we need the NPV to fall by 7,801 to end up with an NPV of zero. If the selling price falls, then the fall in NPV is equal to the fall in the PV of the (after-tax) revenue flows of 43,441. This means the PV of the revenue flows has to fall by 18% and therefore the selling price must fall by 18%.
This is a standard technique that is revision from Paper FM (was Paper F9). If you are still unsure then do watch the free Paper FM lectures on sensitivity analysis in the chapter on uncertainty.
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