How Does Change In Cost Of Capital Affect IRR?


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Hayley Clarke Profile
Hayley Clarke answered
The Internal Rate of Return, or IRR, is not affected by the changing in cost of capital. A change in the cost of capital will not, typically, impact on the IRR. IRR is measure of the annualized effective interest rate, or discount rate, required for the net present values of a stream of cash flows to equal zero.

It is important to compare the IRR to the cost of capital when making investment decisions: If the IRR is higher than the cost of capital the project or investment should be valuable, with a positive Net Present Value (NPV), and if the IRR is lower than the cost of capital it should not be undertaken. The NPV is preferred to the IRR to work out stable investments over time. So, whilst a higher cost of capital will not change the IRR, it will lead to fewer investment decisions being acceptable when using IRR as the method of assessing those investment decisions.

Because the internal rate of return is a rate quantity, it is an indicator of the efficiency, quality, or yield of an investment; the NPV indicates the value or size of an investment. NPV, unlike when one employs the monorating internal rate of return (IRR), has multiple discount rates to evaluate investments and discount each cash flow in accordance with envisaged conditions. Though IRR is simpler and needs fewer assumptions as to the likelihood of yield, NPV is preferred as it is a more accurate measurement of an investment’s yield.
Robert Lamp Profile
Robert Lamp answered

Traditional cash flow analysis (payback) and the accounting rate of return (ROI) fail to consider the time value of money. The internal rate of return (IRR) considers the time value of money and is frequently referred to as the time adjusted rate of return. The IRR is defined as the discount rate that makes the present value of the cash inflows equal to the present value of the cash outflows in a capital budgeting analysis, where all future cash flows are discounted to determine their present values.

The relationships are presented below. The cost of capital represents the minimum desired rate of return (i.e., a weighted average cost of debt and equity capital).

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