The reinvestment rate assumptions that are built into the NPV, IRR and MIRR methods. Introduction: Net Present Value (NPV): It is a method under capital budgeting which includes the calculation of net present value of the project in which the company is investing. The calculation is done by calculating the difference between the value of cash inflow and value of cash outflow after considering the discounted rate. Internal Rate of Return (IRR): It refers to the rate of return that is computed by the company to make a decision regarding the selection of a project for investment. This rate provides the basis for selection of projects with lower cost of capital and rejection of project with higher cost of capital. Modified Internal Rate of Return (MIRR): It refers to the rate of return that is computed by the company to make a decision for the selection and ranking of a project for investment. This is a modified version of the IRR with reinvestment of cash flows at the cost of capital.

Question

An insurance company has liabilities of £7 million due in 10 years' time and £9 million due in 17 years' time. The assets of the company consist of two zero-coupon bonds, one paying £X million in 7 years' time and the other paying £Y million in 20 years' time. The current interest rate is 6% per annum effective. Find the nominal value of X (i.e. the amount, IN MILLIONS, that bond X pays in 7 year's time) such that the first two conditions for Redington's theory of immunisation are satisfied. Express your answer to THREE DECIMAL PLACES.

Answer 1

Question

Chapter 11, Problem 9Q

Summary Introduction

To explain: The reinvestment rate assumptions that are built into the NPV, IRR and MIRR methods.

Introduction:

Net Present Value (NPV):

It is a method under capital budgeting which includes the calculation of net present value of the project in which the company is investing. The calculation is done by calculating the difference between the value of cash inflow and value of cash outflow after considering the discounted rate.

Internal Rate of Return (IRR):

It refers to the rate of return that is computed by the company to make a decision regarding the selection of a project for investment. This rate provides the basis for selection of projects with lower cost of capital and rejection of project with higher cost of capital.

Modified Internal Rate of Return (MIRR):

It refers to the rate of return that is computed by the company to make a decision for the selection and ranking of a project for investment. This is a modified version of the IRR with reinvestment of cash flows at the cost of capital.

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