Opportunity Cost of Capital & IRR

[Atomic_Sheep]

Hello,
1.) Was reading about NPV and the opportunity cost of capital question stumped me somewhat. If we have two independent projects, and if the IRR and NPV rules conflict, we should use the NPV rule to decide on the investment. In the example provided in the textbook:
Project Investment at t = 0 Cash Flow at t=1 IRR(%) NPV at 8%
A -10,000 15,000 50 3,888.89
B -30,000 42,000 40 8,888.89
In this case, we should invest in project B. However, I was thinking… why not invest in A and put the remaining money into a bank account? Perhaps this alternative will produce a higher NPV than investing 30,000 in project B alone? So basically, the question when it comes to NPV analysis is, why do we not consider the opportunity cost of capital in the calculations?
2.) The second question is in relation to IRR. When we find IRR, how do we know that the value we get accounts for all the components of risk i.e.
r = real risk free interest rate + inflation premium + default risk premium + Liquidity premium + maturity premium
The way I see it, when we find r using the IRR formula, we are basically assuming that all the risks are included? Seems to me to be an odd assumption.

 

[S2000magician]

Atomic_Sheep wrote:Hello,
1.) Was reading about NPV and the opportunity cost of capital question stumped me somewhat. If we have two independent projects, and if the IRR and NPV rules conflict, we should use the NPV rule to decide on the investment. In the example provided in the textbook:
Project Investment at t = 0 Cash Flow at t=1 IRR(%) NPV at 8%
A -10,000 15,000 50 3,888.89
B -30,000 42,000 40 8,888.89
In this case, we should invest in project B. However, I was thinking… why not invest in A and put the remaining money into a bank account? Perhaps this alternative will produce a higher NPV than investing 30,000 in project B alone? So basically, the question when it comes to NPV analysis is, why do we not consider the opportunity cost of capital in the calculations?

Your cost of capital is 8%. I don’t know about Australia, but in the US you’re not going to get 8% if you put the rest of the money in the bank. Thus, you’ll be losing money on the remaining $20,000, lowering your NPV (and IRR).

Atomic_Sheep wrote:2.) The second question is in relation to IRR. When we find IRR, how do we know that the value we get accounts for all the components of risk i.e.
r = real risk free interest rate + inflation premium + default risk premium + Liquidity premium + maturity premium
The way I see it, when we find r using the IRR formula, we are basically assuming that all the risks are included? Seems to me to be an odd assumption.

You include all of those components of risk in the threshold rate against which you compare the IRR: your required rate of return.

Atomic_Sheep wrote.S. I’m not sure why it says United States for me, I’m in Australia

I think you can edit your profile and change that.

 

[MrSmart]

1. You’re right. The IRR is a flawed measurement in that regard. The MIRR is a better indicator for benchmarking projects.
2. It doesn’t. The IRR reflects the internal, or inherit risk of the project itself. Any other risk components should be built on the IRR value. But most of the time, they are already estimated in projecting cashflows, so it’s already included in the IRR calculation in this case. Like for example discounting cash flows for probability of default, or increasing real cash flow projections by their respective predicted inflaftion rates.

 

[Atomic_Sheep]

S2000magician wrote:
Your cost of capital is 8%. I don’t know about Australia, but in the US you’re not going to get 8% if you put the rest of the money in the bank. Thus, you’ll be losing money on the remaining $20,000, lowering your NPV (and IRR).

I was more getting at the fact that using NPV formulas, money is just assumed to sit there doing nothing. The way I see it, investing it even in a term deposit might push our NPV value high enough to be better than an alternative investment. I was using a term deposit as an example, Investing it in a stock index might be more realistic in terms of the 8% cost of capital.

MrSmart wrote:
1. You’re right. the IRR is a flawed measurement in that regard. The MIRR is a better indicator for benchmarking projects.

Will have to keep my eye out for the MIRR, haven’t bumped into it yet, thanks.

 

[S2000magician]

MIRR doesn’t appear in the CFA curriculum.
Excel has a built-in MIRR function.

 

[Atomic_Sheep]

I see, thanks.

 

[S2000magician]

My pleasure.