imported>Doug Williamson |
imported>Doug Williamson |
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| ''Investment and funding appraisal.''
| | Monetary policy is central government or other policy to stimulate or otherwise influence economic activity by influencing money supply or interest rates. |
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| (IRR).
| | Historically, mechanisms for influencing the money supply have included the use of open market operations, quantitative easing, the central bank discount rate and reserve requirements. |
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| == Overview of internal rate of return (IRR) == | | ====UK monetary policy==== |
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| IRR is a percentage summary of the cash flows of a project, for example, an IRR of 10%.
| | In recent years the primary objectives of UK monetary policy have been 'stable prices' and confidence in the currency, collectively known as 'monetary stability'. |
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| The IRR summarises the timing, as well as the amounts, of the cashflows.
| | 'Stable prices' are defined by the UK government's inflation target, currently 2% per annum as measured by the UK Retail Prices Index (RPI). |
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| | The objective is to keep inflation close to the target, neither too high nor too low. If inflation moves away from the target by more than 1% in either direction, additional corrective actions will be taken. |
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| For an investor, the IRR of an investment proposal represents their expected rate of [[return]] on their investment in the project.
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| A greater IRR is normally more attractive for an investor.
| | Subject to the primacy of the inflation target, the secondary objectives of monetary policy in the UK are to support the government's other economic objectives, including those for growth and employment. |
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| The IRR is driven by the expected future cash flows from the project.
| | Responsibility for setting UK monetary policy - to achieve monetary stability - lies with the Bank of England's Monetary Policy Committee (MPC). |
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| The IRR of a set of cash flows is:
| | Monetary policy in the UK has usually operated through setting the Bank of England's interest rate, the Official Bank Rate, or 'Bank Rate'. |
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| :the [[cost of capital]] which,
| | The Official Bank Rate is sometimes referred to as the 'Bank of England Base Rate'. |
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| :when applied to discount all of the cash flows,
| | ====Quantitative easing in the UK ==== |
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| :including any initial investment outflow at Time 0,
| | In 2009, in addition to setting Official Bank Rate, the MPC started quantitative easing (QE). |
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| :results in a [[net present value]] (NPV) of 0.
| | This means injecting money directly into the economy by purchasing financial assets. |
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| | | QE is designed to stimulate the economy further, beyond what could be achieved by low interest rates alone. |
| <span style="color:#4B0082">'''Example 1: IRR - single period 10%'''</span>
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| A project requires an investment today of $100m, with $110m being receivable one year from now.
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| The IRR of this project is 10%, because that is the cost of capital which results in an NPV of $0, as follows:
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| [[PV]] of Time 0 outflow $100m
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| = $(100m)
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| PV of Time 1 inflow $110m
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| = $110m x 1.10<sup>-1</sup>
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| = $100m
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| NPV = - $100m + $100m
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| = '''$0'''.
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| <span style="color:#4B0082">'''Example 2: IRR - single period 5%'''</span>
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| A project requires an investment today of $100m, with $105m being receivable one year from now.
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| The IRR of this project is 5%, because that is the cost of capital which results in an NPV of $0, as follows:
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| [[PV]] of Time 0 outflow $100m
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| = $(100m)
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| PV of Time 1 inflow $105m
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| = $105m x 1.05<sup>-1</sup>
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| = $100m
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| NPV = - $100m + $100m
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| = '''$0'''.
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| <span style="color:#4B0082">'''Example 3: IRR - two periods 5%'''</span>
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| A project requires an investment today of $100m, with $5m being receivable one year from now, and $105m two years from now.
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| The IRR of this project is 5%, because that is the cost of capital which results in an NPV of $0, as follows:
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| [[PV]] of Time 0 outflow $100m
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| = $(100m)
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| PV of Time 1 inflow $5m
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| = $5m x 1.05<sup>-1</sup>
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| = $4.76m
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| PV of Time 2 inflow $105m
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| = $105m x 1.05<sup>-2</sup>
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| = $95.24m
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| NPV = - $100m + $4.76m + $95.24m
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| = '''$0'''.
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| <span style="color:#4B0082">'''Example 4: IRR - three periods 5%'''</span>
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| A project requires an investment today of $100m, with $5m being receivable one year from now, a further $5m two years from now, and $105m three years from now.
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| The IRR of this project is 5%, because that is the cost of capital which results in an NPV of $0, as follows:
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| [[PV]] of Time 0 outflow $100m
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| = $(100m)
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| PV of Time 1 inflow $5m
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| = $5m x 1.05<sup>-1</sup>
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| = $4.76m
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| PV of Time 2 inflow $5m
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| = $5m x 1.05<sup>-2</sup>
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| = $4.54m
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| PV of Time 3 inflow $105m
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| = $105m x 1.05<sup>-3</sup>
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| = $90.70m
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| NPV = - $100m + $4.76m + $4.54m + $90.70m
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| = '''$0'''.
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| == Project decision making with IRR ==
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| Target or required IRRs are set based on the investor's [[weighted average cost of capital]], appropriately adjusted for the risk of the proposal under review.
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| In very simple IRR project analysis the decision rule would be that:
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| (1) All opportunities with above the required IRR should be accepted.
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| (2) All other opportunities should be rejected.
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| However this assumes the unlimited availability of further capital with no increase in the cost of capital.
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| A more refined decision rule is that:
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| (1) All opportunities with IRRs BELOW the required IRR should still be REJECTED; while
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| (2) All other opportunities remain eligible for further consideration (rather than automatically being accepted).
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| == Excel's =IRR() function ==
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| Excel's =IRR() function returns the IRR for a block of cells within a single row or column, specified as a range.
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| <span style="color:#4B0082">'''Example 5: =IRR() function'''</span>
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| Cell A1 contains -100.
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| Cell A2 contains 110.
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| =IRR(A1:A2)
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| will return '''10%'''.
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| (This is the result we saw in Example 1 above.)
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| == Determining IRR manually ==
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| Unless the pattern of cash flows is very simple, it is normally only possible to determine IRR manually by trial and error (iterative) methods.
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| <span style="color:#4B0082">'''Example 6: Straight line interpolation'''</span>
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| Using straight line interpolation and the following data:
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| First estimated rate of return 5%, positive NPV = $+4m.
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| Second estimated rate of return 6%, negative NPV = $-4m.
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| The straight-line-interpolated estimated IRR is the mid-point between 5% and 6%.
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| This is '''5.5%'''.
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| Using iteration, the straight-line estimation process could then be repeated, using the value of 5.5% to recalculate the NPV, and so on.
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| The IRR function in Excel uses a similar trial and error method.
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| == See also == | | == See also == |
| * [[Cost of capital]] | | * [[Bank of England]] |
| | * [[Deflation]] |
| * [[Discount rate]] | | * [[Discount rate]] |
| * [[Discounted cash flow]] | | * [[Financial Policy Committee]] |
| * [[Effective interest rate]] | | * [[Fiscal policy]] |
| * [[Funding]] | | * [[Inflation]] |
| * [[Hurdle rate]] | | * [[Interest rate]] |
| * [[IBR]] | | * [[Keynesianism]] |
| * [[Implied rate of interest]]
| | * [[Monetary]] |
| * [[Interpolation]] | | * [[Monetary Policy Committee]] |
| * [[Investment appraisal]] | | * [[Money supply]] |
| * [[IRI]] | | * [[Open market operations]] |
| * [[Iteration]] | | * [[Quantitative easing ]] |
| * [[Linear interpolation]] | | * [[Reserve requirements]] |
| * [[Market yield]] | | * [[Retail Prices Index]] |
| * [[Net present value]] | | * [[Supply side policy]] |
| * [[Present value]] | | * [[ZLB problem]] |
| * [[Return on investment]] | |
| * [[Shareholder value]]
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| * [[Time value of money]]
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| * [[Weighted average cost of capital]]
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| * [[Yield to maturity]]
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| [[Category:The_business_context]]
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| [[Category:Corporate_finance]]
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| [[Category:Investment]]
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| [[Category:Long_term_funding]]
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| [[Category:Cash_management]]
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| [[Category:Financial_products_and_markets]]
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| [[Category:Liquidity_management]]
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| [[Category:Trade_finance]]
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Monetary policy is central government or other policy to stimulate or otherwise influence economic activity by influencing money supply or interest rates.
Historically, mechanisms for influencing the money supply have included the use of open market operations, quantitative easing, the central bank discount rate and reserve requirements.
UK monetary policy
In recent years the primary objectives of UK monetary policy have been 'stable prices' and confidence in the currency, collectively known as 'monetary stability'.
'Stable prices' are defined by the UK government's inflation target, currently 2% per annum as measured by the UK Retail Prices Index (RPI).
The objective is to keep inflation close to the target, neither too high nor too low. If inflation moves away from the target by more than 1% in either direction, additional corrective actions will be taken.
Subject to the primacy of the inflation target, the secondary objectives of monetary policy in the UK are to support the government's other economic objectives, including those for growth and employment.
Responsibility for setting UK monetary policy - to achieve monetary stability - lies with the Bank of England's Monetary Policy Committee (MPC).
Monetary policy in the UK has usually operated through setting the Bank of England's interest rate, the Official Bank Rate, or 'Bank Rate'.
The Official Bank Rate is sometimes referred to as the 'Bank of England Base Rate'.
Quantitative easing in the UK
In 2009, in addition to setting Official Bank Rate, the MPC started quantitative easing (QE).
This means injecting money directly into the economy by purchasing financial assets.
QE is designed to stimulate the economy further, beyond what could be achieved by low interest rates alone.
See also
