Question

Assume your firm has multiple investments to consider each with differing risk levels. How can differing risk levels be incorporated into NPV analysis? How can they be incorporated into IRR analysis?

Answer 1

The npv of a project is calculated by discounting the future cashflow at cost of capital or required rate of return less initial investment. A project is acceptable if the npv of the project is positive. The cost of capital includes the riskiness of the project and is higher for more risky project. Thus the projects with different risk levels will have different cost of capital depending on their riskiness and hence their npv will be different. In this case project with highest positive npv is accepted.

In the case of IRR, a project is accepted if the irr of the project is higher than the cost of capital. The cost of capital of any project depends on the riskiness of the project. Thus a project with higher risk will have higher cost of capital and lower chance of irr being higher than the cost of capital. Thus in the case of irr also the riskiness of the project is included in cost of capital.