Question

analyze the reasons why the short-term project that you have chosen might be ranked higher under the NPV criterion if the cost of capital is high, while the 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

The cost of capital reflects the minimum amount that a firm must earn on its assets in order for those assets to add value to the firm. The cost of capital is the rate at which assets must provide cash inflows to justify their cost. Therefore, if the rate of return of the net cash flows from a project, including the initial investment and all future net cash flows, exceeds the cost of capital, the project will add to the value of the firm.

Therefore Cost of Capital plays a crucial role in ranking the projects.

If the project lifetime is short, the impact of changing value of money over time is also not clearly visible. Therefore, the difference in the cost of capital may not be as significant in the case of short-term projects as the level of cash flows.

Whereas, In the case of long-term projects, the impact of value of money is higher and money is taken into consideration in discounted basis. This means that even a small change in the cost of capital can cause a very significant difference in the net present value. This is related to the long-term effect of the discount rate, which is increasingly decreasing the value of cash flows.

Therefore, in the case of short-term projects, we must pay special attention to the amount of cash flows, while in long-term projects the amount of cost of Capital.

Changes in cost of capital have no effect on IRR. IRR tells us about the cost capital where NPV will be equal to 0. So it is not important what is the cost of capital when calculating IRR.

For example - Lets suppose the cost of capital = 5% and IRR = 3%, the change in the cost of capital to 7% will not change the IRR and will still be equal to 2%.