IRR and opportunity cost of capital

1. www.futurumcorfinan.com
Page 1
IRR and Opportunity Cost of Capital
Preface
During the training class, I kept getting the question from the training participants about Internal
Rate of Return (IRR).
In general, the participants know that IRR is the rate that makes NPV of the project equal to
zero.
But the big question, then so what? How to interpret IRR intuitively?
To answer this question, I need first to make sure the participants to understand the difference
between IRR and the opportunity cost of capital for the project because there is always
confusion or misunderstanding about these two concepts as both appear or used as “discount
rate” in the Net Present Value (NPV) formula.
IRR as explained in my article or writing titled “Internal Rate of Return: Perhitungannya
sederhana tapi tidak sederhana”, is calculated “internally”, totally and solely dependent on the
AMOUNT and TIMING of the project cash flows. IRR calculation puts “the market rate” outside
the window! You might even do this IRR in your room where you color all the window glasses
black so that you won’t know whether the sun is up or down.
Sukarnen
DILARANG MENG-COPY, MENYALIN,
ATAU MENDISTRIBUSIKAN
SEBAGIAN ATAU SELURUH TULISAN
INI TANPA PERSETUJUAN TERTULIS
DARI PENULIS
Untuk pertanyaan atau komentar bisa
diposting melalui website
www.futurumcorfinan.com

2. www.futurumcorfinan.com
Page 2
As IRR is a PROFITABILITY MEASURE, then it is easier to understand it if we compare that
IRR to “something”.
To generate profit, it takes money to make money, and the company needs to get financing to
fund that investment.
That “something” above is the company’s cost of fund. If the company’s cost of fund is lower
than that IRR, then the project will generate positive NPV.
So IRR vs cost of fund. That’s the key. Cost of fund to finance the project vs IRR. IRR – cost of
fund = the profit.
Hope now you could see the point.
How about the opportunity cost of capital of the project?
Remember that the discount rate used to discount for the streams of the cash flows of the
project in the NPV analysis is not taken from your project’s IRR or project’s cost of fund.
The opportunity cost of capital is a STANDARD OF PROFITABILITY for the project (you could
call this “hurdle rate”) which we will use to calculate how much the project is worth at today’s
value of money (=today’s dollars or Rupiahs).
The opportunity cost of capital is, which is totally different from IRR, established in the capital
markets. You can’t get your opportunity cost of capital by sitting in your room in totally
blackened window glasses. You need to get the help from the market participants or market
players to give you the expected rate of return offered by other financial assets equivalent in risk
to the project being evaluated.
In other words, the opportunity cost of capital can only make financial sense if and only if assets
of equivalent risk are compared. In general, you should:
 identify financial assets with risk profile comparable or equivalent (I don’t say, exactly
similar) to the project being evaluated,
 estimate the expected rate of return on these financial assets, and use this “expected” or
“required” rate as the opportunity cost of capital.
In a very direct method, you even could go the market participants or players or investors and
ask them how much required rate of return for them to part themselves from their money and

3. www.futurumcorfinan.com
Page 3
invest that money into the project. This is what I call “interview method” but again, you need to
go the market. You need to put your foot on the ground!
The project’s opportunity cost of capital then is about the rate of return invested in the project
vis-à-vis invested in the same money in the capital market or other risk-equivalent financial
assets. So instead of putting the hard-earned money of the investors in the project, the same
money could remain with the investors and let them invest it in the financial assets or capital
markets.
The most interesting about the project’s discount rate or opportunity cost of capital is that it is
nothing to do with the company’s interest rate on the loan. For example, a project is under
consideration and your banker is willing to lend the project with a loan facility by charging the
annual interest rate at 11%. Will that mean that the cost of capital for that project is 11%. This is
not correct!
As we know that the opportunity cost of capital for an investment project is the expected or
required rate of return demanded by market investors in financial assets or capital markets
subject to the equivalent risk as the project.
So the key words are to find the expected rate of return with comparable risk of the project. The
loan interest rate offered by your banker is nothing to do with the risk of the project at all. Either
you are willing or not to take up the loan facility from your banker, you will still face the choice
between
(a) the project under consideration, let’s say offering an expected rate of return of 15% a year,
or
(b) the expected rate of return from investments in financial assets or securities in capital
markets with equally risk profile, which, let’s say could generate an expected rate of return of
20% a year.
So it is financially stupid for the corporate management to get the loan facility from your banker
with a cost of fund of 11% a year and then using that money in the project that could bring 15%
rate of return per year, yet at the same time, your company’s investors could borrow the same
amount of money with the same cost of fund of 11%, but could invest that money in capital
markets, earning them with a rate of return of 20% per year. So the project’s opportunity cost of
capital IS NOT 11%, your banker’s interest rate, but 20%, the rate of return per year by
investing in an equally or comparable risky investment.

4. www.futurumcorfinan.com
Page 4
Again, the opportunity cost of investing in a project is the expected return will depends on the
market risk of the comparable risky financial assets. So the project’s “true” opportunity cost of
capital depends wholly on the project risk and not on the company management whether
undertakes that project or not. We even could boldly say that the project’s opportunity cost of
capital does not depend at all on whether the project is financed by debt instrument, equity
instruments, retained earnings, new stock issue, etc. At the end of the day, it is the market rates
of return that matters to the project being under consideration for investment.
We could compare IRR analysis vs NPV analysis:
 IRR analysis solely depends on the amount (=size, scale) and timing of the cash flows
profile of the projects, but
 NPV analysis solely depends on the forecasted cash flows from the project (this will
involve the size/amount and the timing of the cash flows profile of the project as well as
we see in the IRR analysis above), but also the opportunity cost of capital of the project.
A word of caution, though it is easy to define the opportunity cost of capital, but it is not possible
to measure it precisely.
All we have at the moment is just to estimate it.
Capital Asset Pricing Model (CAPM) said that there is a positive relationship between expected
rate of return and the beta of the project (in a portfolio context, a financial asset’s risk is
measured by beta).
However, in general cases, the investors will look at the opportunity cost of capital estimated
from historical returns. Please remember though historical rate of returns were evaluated using
compound annual rates of return, but for estimation to the future, always use the arithmetic
averages.
The difficulty in estimating the project’s opportunity cost of capital is partially connected to the
nature of the project life which in many cases, is more than one year, even extends to more
than 5 years. The question is who can see the future???
Please remember that the project’s opportunity cost of capital (= discount rate) stands on the
solid rock, that is, wise investors don’t take risks of the project for fun! It is the real money (and
not monopoly money) that will be put into the project!
~~~~~~ ####### ~~~~~~

5. www.futurumcorfinan.com
Page 5
Disclaimer
This material was produced by and the opinions expressed are those of FUTURUM as of the date of
writing and are subject to change. The information and analysis contained in this publication have been
compiled or arrived at from sources believed to be reliable but FUTURUM does not make any
representation as to their accuracy or completeness and does not accept liability for any loss arising from
the use hereof. This material has been prepared for general informational purposes only and is not
intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors
for specific advice.
This document may not be reproduced either in whole, or in part, without the written permission of the
authors and FUTURUM. For any questions or comments, please post it at www.futurumcorfinan.com
© FUTURUM. All Rights Reserved