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My lecturer said:
In NPV, we discount down cash flows to present value figures at the cost of capital. For instance (just for the purpose of understanding), we discount down a future cash flow of 200 $ to a present day value of 180 $. This is, kind of, like our opportunity cost. I know that I can get the cost of capital. I know that I can reinvest it. That’s what I normally do. People give me money. They expect a certain amount of return. And that’s what I give them. That’s my cost of capital. So if you give me 200$, I should at least be able to make the cost of capital. That is what NPV is assuming that you can make (at least ) the cost of capital. So when we discount it down, we are taking the opportunity cost of not being able to make that just yet.
When we are looking at IRR though, the IRR calculates a percentage. We are presuming that you can now discount down at the IRR of this project. If you have a particularly good project that is making 40 %, you are presuming that you can use all of your cashflows elsewhere and also get 40% which is actually not really true.
Therefore, the assumption made by NPV is far more realistic. ”
QUERY: I don’t understand how the cost of capital signifies an opportunity cost.
I also don’t get why we assume that the IRR is our new cost of capital???
The cost of capital signifies an opportunity cost because it represents the return that could have been earned if the money was invested elsewhere. When we discount future cash flows to their present value using the cost of capital, we are essentially accounting for the return that investors expect to earn on their investment.
Regarding the IRR, it is the rate at which the net present value (NPV) of a project is zero.
The assumption made by IRR is that the cash inflows generated by the project can be reinvested at the same rate as the IRR. This can be unrealistic because it assumes that the project will continue to generate returns at the same high rate, which may not always be possible.
So the NPV method, which assumes reinvestment at the cost of capital, is often considered more realistic.
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