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What are the reinvestment rate assumptions for NPV and IRR and the issues with that? What...

  1. What are the reinvestment rate assumptions for NPV and IRR and the issues with that?
    • What does WACC represent and how to adjust for risk?
    • Explain Sinking fund provisions and whether that adds or takes away risk from a bond?
    • What is market risk and what is it measured by and how to eliminate it?
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Answer #1

Part A: Reinvestement rate assumption is the assumption that the formula for NPV and IRR uses. It assumes that the cashflows generated from the project can be reinvested into the project at the IRR of the project. As we know, the reinvestment opportunities may not be similar as the projects cannot be linearly scaled up, if it would have been so, we could have the opportunity to generate the same rate of return and our assumption would have made sense. So, the underlying issue is that if we cannot reinvest the cashflows generated at the a rate greater than or equal to the IRR then the return as shown by the IRR would decrease and hence the NPV shall decrease too.

Part B: WACC represents the cost at which company sources its capital. Now, WACC is dependent on three parameters:

a) Capital structure: weightage of debt and equity in the portfolio

b) Post-tax cost of debt: the tax rate and risk associated to the company's debt defines the post tax cost of a company's debt

c) Cost of equity: depends on the risk of the company as compared to the broad market portfolio, due to this addetive risk the cost of equity is priced by the additional risk and is derived by the Capital Asset Pricing Model

Overall, hence, WACC is weighted average of a company's cost of debt and equity based upon it's capital structure. Now, a change in risk is priced into the debt and equity components, the percieved volatilty is factored in through the Beta of the CAPM model and hence adjusts WACC as per risk. On the other hand, bonds are priced as per the percieved risk of the security and for a company's debt, it would be priced accordingly by the lender. Hence, WACC prices in the risk, a lower risk stable company shall have a lower WACC as compared to a high growth nascent firm.

Part C: A sinking fund is a provision against a bond made by the company who's issuing bonds to add a layer of security against the bond for the lender. The basic provision is that the issuer shall keep aside a portion of the bond's maturity value for safekeeping using which at specific intervals it can even retire the bond by repurchasing it. Bonds backed by sinking fund facilities have interest rates lower than bonds without them due to an extra layer of the security. Though it does provide some safekeeping but it is counterintuitive to shell out some money for safekeeping while borrowing. The only reason the concept was introduced because that the bond's major repayment is at its maturity which is quite far into the future unlike loans or debt, hence sinking fund gives the lenders some reassurance that they shall not be losing all the capital in case of a potential downside as well.

Part D: Market risk is the risk that you take up when you invest into any market be it debt or equity market. Even the risk-free rate is payed for you to defer your spending to a future date, in essence it as well carries some risk and hence you are paid a premium for taking up that risk (no economy in the world event the US economy can be called risk-free, though it's extremely safe). Now, when you invest into debt or equity markets the risk that you take is of market eroding your investments. There are two types of risk: systemic and non-systemic risk, risk that you take when you invest into a particular company is unsystemic risk which is company specific risk driven by your choice into a specific company and industry. Unsystemic risk can be minimized by investing into a diversified set of companies. Systemic risk is the underlying risk in the entire market portfolio/asset class, which can be only be reduced by diversification into other asset classes. A risk of equity markets falling due to a pandemic is a systemic risk which can only be minimized by investing into multiple asset classes like gold, debt etc.

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