Question

Suppose that your company’s weighted-average cost of capital is 9 percent. Your company is planning to undertake a project with an internal rate of return of 12%, but you believe that this project is not a good investment for the firm. What logical arguments might you use to convince your boss to forego the project despite its high rate of return? Is it possible that making investments with expected returns higher than your company’s cost of capital will destroy value? If so, how?

Answer 1

It is possible that making investments with expected returns higher than the company's cost of capital will destroy value. The following reasons are listed below:

1. Major assumption of Internal rate of return methodology is that the interim cash flows will be reinvested at the same high rates of return (in this case 12%) , which may not necessarily hold true
2. Internal rate of return methodology assumes that the company has additional projects with equally attractive prospects, in which it can invest interim cash flows
3. Internal rate of return methodology's assumptions about reinvestments can lead to major capital budget distortions.    For eg: Consider a hypothetical assessment of two projects , A & B, with identical cash flows , risk levels and durations as well as identical Internal rate of return values of 12%. Using Internal rate of return as a decision making yardstick, an executive would feel confidence in being indifferent toward chosing between the two projects. However, it would be a mistake to select either project without examining relevant reivestment rate for interim cash flows. Suppose Project B's interim cash flow can be redeployed only at a typical 9% cost of capital, while Project A's cash flows could be reinvested in an attractive follow on project of 12%, Project A is unambiguously preferable. The above logical arguments can be used to convince to forego the project despite its high internal rate of return.