[Anonymous]

Net present value (NPV) assumes that the cash flows you get from the project are reinvested at the company’s cost of capital.

Internal Rate of Return assumes that the cash flows you get from the project are reinvested at the Internal Rate of Return.

Let’s assume the IRR of a project is higher than the company’s cost of capital. Generally companies don’t invest if the IRR is less than the cost of capital.

I’m wondering how the IRR assumption is possible in this situation as if you have a project which earns the IRR and is discounted at the IRR, the NPV is supposed to be zero. But when we do NPV calculations, we discount at the cost of capital which in this case is lower than the IRR.

If the IRR assumption is true, then the NPV would still be be positive but not zero, since NPV discounts at a lower rate than the IRR. If you reinvest at the IRR, then you’re getting more cash flow than if you’re investing at the cost of capital.

So where am I going wrong here?

[Anonymous]

Wish I could help you here…at some point it seemed like all I was reading was blahblahblah…I don't think I really understood this topic fully when I studied it 🙁

Maybe someone else can help you out here, but if not I'll try to look up this topic in my review book tomorrow and refresh my memory…

[See Pee A]

IRR and NPV are two different things. NPV you have correct as cash flows that are discounted (typically at WACC). IRR is the rate of return that gives you a 0 (zero) NPV. IRR helps a manager determine what rate of return is needed to “breakeven”, so to speak.

If IRR>WACC, then it's “good” since it's a positive NPV project.

If IRR<WACC, then it's “bad” since it's a negative NPV project.

Tough topic, but if you don't really understand it, it's pretty easy to memorize. Only two situations. Good luck!

BEC 86 (08/30/11)
FAR 84 (10/13/11)
REG 88 (11/08/11)
AUD 86 (11/29/11)

Exam prep - Becker self-study

[Anonymous]

@bobkorz.

One of the difference between IRR and NPV is IRR is not pre-determined whereas NPV has a known set rate, usually hurtle rate or cost of capital (%). When you calculate NPV, the rate has been set/known by the manager who also take re-investment into consideration. For example, 12%. The purpose of the NPV calculation is to see if the projected cash flow sufficient enough to cover/surpuss the 12% requirement. In this case, the cash flow AND the rate is set to arrive the NPV.

On IRR, the rate is NOT hurtle rate or already known. The IRR is determined by the projected cash flow and the initial capital investment. IRR rate could be viewed as a “break-even” rate, a rate to discout future cash flow to make the project a zero value. Therefore, it could be higher or lower than the hurtle rates, and you just need to calculate it.

From your question, I think you are confused with NPVs calculated by IRR and NPV. You asked if the project is earning at IRR rate, then the NPV is zero. Your assumption is true ONLY when the IRR equals the hurtle rate/cost of capital.

[kmcg4k]

NM 457- posted 73 BEC

@ See Pee A did you already post your study advice to those of us who are struggling. I see you used Becker self study and i have too, i need to get out of the 70's into the 80's- how did you do it? Cannot afford this any longer….

Thank you! & Congrats!

REG 79 - LOST IT
BEC 74 74 73
AUD 71 79!!! LOST IT
FAR

[Anonymous]

I see people answered your question…guess I don't have to look it up now.

[Author]

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