Question

Please explain what is Internal rate of return (IRR), Cost of Capital, NPV, and the Discount Rate.

How are they associated when deciding on an investment opportunity?

Answer 1

Ans ) Cost of capital refers to the opportunity cost of making a specific investment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk. Thus, the cost of capital is the rate of return required to persuade the investor to make a given investment.

Internal rate of return :

The internal rate of return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments. The internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero.

What is the IRR Formula?

The IRR formula is as follows:

Discount rate : the rate of return that the investors expect or the cost of borrowing money. If shareholders expect a 12% return, that is the discount rate the company will use to calculate NPV. If the firm pays 4% interest on its debt, then it may use that figure as the discount rate. Typically the CFO's office sets the rate.

The all the above rates are associated while calculating the cost of capital.

Internal Rate of Return is widely used in analyzing investments for private equity and venture capital, which involves multiple cash investments over the life of a business and a cash flow at the end through an IPO or sale of the business.

Thorough investment analysis requires an analyst to examine both the net present value (NPV) and the internal rate of return, along with other indicators, such as the payback period, in order to select the right investment. Since it’s possible for a very small investment to have a very high rate of return, investors and managers sometimes choose a lower percentage return but higher absolute dollar value opportunity. Also, it’s important to have a good understanding of your own risk tolerance, or a company’s investment needs, risk aversion, and other available options.