Question

Analyze the reasons why a short-term project might be ranked higher under the NPV criterion if the cost of capital is high, while a long-term project might be deemed better if the cost of capital is low. Determine whether or not changes in the cost of capital could ever cause a change in the internal rate of return (IRR) ranking of two (2) projects.

Answer 1

As we know that cost of capital affects real value of cash inflows from a given project because cash inflows are discounted with the help of given cost of capital. Thus short-term project will be ranked higher under the NPV criteria if the cost of capital is high because in case of high cost of capital, actual discounted cash inlows will be higher in short-term in compare to long-term. As we know that as the time passes then discounted value of cash inflows will be lower that is as a result NPV in short-term will be higher and in long-term will be lower. Thus short-term project will carry higher rank while long-term project will carry lower rank in case of high cost of capital.

So in opposite case when cost of capital is low then long-term project will be better due to low discounted rate for long-term cash inflows.

Yes, it is also true that change in cost of capital will definitely affect IRR decision because cost of capital is the parameter for making decision on the basis of IRR. Thus we can say that an incresae or decrease in cost of capital may affect decision of choosing project from given option because we need to compare cost of capital (minimum required return) and IRR of a project for choosing correct & profitable project.

Hence there is relation between change in cost of capital and IRR and its related decisions.