BUSF_A01.qxd

Internal rate of return

Figure 4.1
Graph of the NPV
against the discount
rate for two projects
(A and B)

As the discount rate increases, NPV decreases. The discount rate at zero NPV is the IRR. The

rate at which NPV decreases differs from one project to another. Whereas Project A has the

higher NPV where the discount rate is below about 11.3 per cent, Project B has the higher

NPV where the discount rate is higher than 11.3 per cent. This leads to a conflict between

the signals given by NPV and IRR, where the discount rate is less than 11.3 per cent.

At about 11.3 per cent the NPVs of the two projects are equal (at about £200).

opportunitycost of finance. That is, it is the cost of funds raised to support the project or, if

funds are available already, it is the rate that they could alternatively earn. According to the

basic principles of NPV, referred to earlier in this chapter, this is the borrowing/lending rate.

Using IRR, on the other hand, requires the assumption that the opportunity cost of finance

is equal to the IRR, so that funds generated by the project could either be used to repay

finance raised at the IRR or be reinvested at that rate. Clearly this is illogical: why should it

be the case here that if Project A is undertaken the opportunitycost of finance is 13 per cent,

whereas if Project B is pursued it suddenly becomes 14 per cent? The choice by a particu-

lar business of specific projects would not alter the economic environment so that either the

cost of finance or the investment alternatives change with the business’s decision.