5) The Investment Decision-Making Process

Question 1

How do you work out the present value of the future value you will receive from an investment?

Answer 1

Present Value = Future Value x Discount Factor

Question 2

Formula to calculate IRR using linear interpolation?

Answer 2

IRR = L + (N(Low)/[N(Low) - N(High)]) x (H - L)

Where: L = Lower rate of interest, H = Higher rate of interest
N(Low) = NPV at lower rate of interest, N(High) = NPV at higher rate of interest

Note: do not use rates which are too far apart. A 5% difference should be sufficient. The further the rates are away from each other than the greater the amount of error in the IRR calculation.

Using one positive and one negative NPV. Though not essential, this will usually increase the accuracy of your answer. If the first NPV you calculate is positive, choose a higher discount rate for your second calculation to try to get a negative NPV, and vice versa if your first answer gives a negative NPV.

Question 3

Calculate IRR of an annuity

Using annuity table (also called cumulative PV table)

Answer 3

Look along the row in the table for the number of years of the annuity (n), until you get to the column with the decimal discount factor that is closest to your calculated cumulative discount factor (initial investment / annual inflow), then look to the top of that column to find the relevant IRR %

Question 4

Calculate IRR of a perpetuity

Answer 4

Annual inflow/Initial investment x 100