Question 7.Act.15: Assume that: (a) Ippo Ltd (see Example 7.4) provides additio...
Assume that:
(a) Ippo Ltd (see Example 7.4) provides additional ordinary share capital at the beginning of the investment period of £60 million, thereby eliminating the need for Andante Ltd to take on a bank loan
(b) any cash flows generated by Andante Ltd would be received by Ippo Ltd in the form of annual dividends.
What would be the IRR of the total investment in Andante Ltd for Ippo Ltd?
The IRR can be calculated using the trial and error method as follows. At discount rates of 10 per cent and 16 per cent, the NPV of the investment proposal is:
| Trial 1 | Trial 2 | ||||
| Year | Cash flows | Discount rate | Present value | Discount rate | Present value |
| £m | 10% | £m | 16% | £m | |
| 0 | (140.0) | 1.00 | (140.0) | 1.00 | (140.0) |
| 1 | 20.0 | 0.91 | 18.2 | 0.86 | 17.2 |
| 2 | 20.0 | 0.83 | 16.6 | 0.74 | 14.8 |
| 3 | 20.1 | 0.75 | 15.1 | 0.64 | 12.9 |
| 4 | 175.0 | 0.68 | \underline{119.0} | 0.55 | \underline{96.3} |
| NPV \underline{28.9} | NPV \underline{1.2} | ||||
The calculations reveal that, at a discount rate of 16 per cent, the NPV is close to zero.
Thus, the IRR of the investment is approximately 16 per cent, which is lower than the cost of capital. This means that the investment will reduce the wealth of the shareholders of Ippo Ltd.