ECR-several questions!

Re:ECR-several questions!

about your first question Gem, if you have a look at suggested answers for past papers (december 2005 exam), cost unit on the cost card contains 3 decimal places, so i think maybe your tutour is right.
Don't worry too much, your head needs to be fresh before exam. everything will be fine!:)

Re:ECR-several questions!

Thanks for all your help.

We were told we wouldn't have to calculate the IRR, thats why I haven't bothered thinking too much about the percentages. Hopefully it won't come up in great detail in the exam!

Thanks again

Gem

p.s did everyone like my textbook answer of the definition of IRR? :P

Re:ECR-several questions!

I know in basic that the IRR is the discount or Interest rate that will bring the NPV of a set of cash flows to zero

Gem

To understand this correct statement, you must understand the whole idea of Net Present Value (or Discounted cash Flow) and there can (and very probably will) be a question in your exam on this topic.

If you are planning a project there will almost certainly be capital expenditure at the beginning to set things up, then there will be operations which I trust will generate more cash than they cost.

So over the life of the project you pay out cash early on and later have cash coming in.

Because money received in the future has a lower value today than money received (or paid out) today you discount future cash flows.

Please say if that sounds like double dutch.

Would you rather have £100 now, or wait a year to receive the same £100?

Exactly how much is the present value of the £100 we have to wait a year for?

It depends on the discount rate (or cost of borrowing or a series of expressions that mean the same thing).

For a lot of businesses the rate they pay on their overdraft is used as the discount rate.

So if your firm gets a 10% rate of interest on the overdraft you would probably use the 10% rate to discount your future cash flow.

£100 that we have to wait a year for has a value today of £100 divided by 110% (after all a sum of money invested at 10% would be worth that amount multiplied by 110% in a year's time)
I reckon that is approx £90.91

And because interest is a compound rate the discount to apply must also be compounded. If you have to wait 2 years for £100, then at 10% the value of the £100 is £100 divided by 110% and divided by 110% again rather than being divided 2 x 110%.

So £100 that won't arrive for 2 years has a present (day) value of £82.64.

In an NPV or DCF question the examiner asks what the net effect is;

You have to pay out so much now

Each year you have a present value of the cash you will receive that year

So in the end you have the Net Present Value of the project

If it's positive it'll add value to the business, if it's negative then the business would not be worth as much if it went ahead.

If you want to find the IRR you would be looking at the rate you used to discount the future cash flows.

Say, in my example where we discounted the future cash flows at 10%, we had a positive NPV.
Then if we were to increase the rate say to 12% or 15% or even 20% then each time we increase the rate the NPV will fall, and at some point the NPV will be £0. The discount rate that causes the NPV to be £0 is called the Internal Rate of Return of the project.

Re:ECR-several questions!

Gem
Try to see two different rates

The rate we use to discount future cash flows

The internal rate of return we find by calculation

You are absolutely right about the higher the rate we use to discount cash flows the lower our NPV.
I gather that the 0.25% increase in the bank base rate is costing anyone with a variable rate mortgage for say £100,000 a fortune at the moment.

But if we have a few business ideas, and

(1)will give us an IRR of 15%

(2)will give us an IRR of 20%

Then (2) has a better % return

After all, if we had to borrow at 18% (1) would not be worth it because it would have a negative NPV whereas (2) would give a positive NPV