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8.
In your own words define rate of return, ROR.
The
Compound interest rate that makes NPV equal to zero.
9.
We said that ROR is the discount rate that will set
discounted positive cash flow exactly equal to discounted
negative cash flow (or will set NPV exactly equal to
zero). Now we need to understand the trial and error
calculations that make up the interpolation process
used to actually find the value of "i" that makes our
NPV equation equal to zero.
As
we do this we will determine the interest rates at which
NPV changes sign, that is, it goes through zero and
changes sign from positive to negative or vice versa.
Why
will this tell us that we are close to the correct ROR
value?
Because
the correct value of ROR will set NPV exactly equal
to zero, and in our calculations NPV will have passed
through the zero point.
10.
When we have determined the interest rates at which
NPV changes sign (passes through zero) we can then calculate
the ROR more accurately by linear interpolation.
Linear
interpolation is the process of finding values between
any two consecutive terms of a series assuming straight
line variation of the values in between the known values.
If
we had tables for all possible interest rates we could
find the correct one. But because there are no tables
in the reference text for, say, ROR = i = 16%, we must
calculate the desired values by ____________________ between ROR values of
15% and 20%.
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