Scenario: A friend of mine Randy called me the other night with what he thought
ID: 2695222 • Letter: S
Question
Scenario: A friend of mine Randy called me the other night with what he thought was a great riddle for me. He told me that if I get it right, he will send a case of fresh orange juice to me. He said two mutually exclusive projects are being considered. First, a short-term project might have a higher ranking under the NP criterion if the cost of capital is high. However, and here is where he lost me, a long-term project might be better if the cost of capital is low. Why is that? He asked me if changes in the cost of capital would ever create a change in the IRR ranking of these two projects. What do you say?Explanation / Answer
A low cost of capital favors a longer term project because the cash flow received long into the future is not discounted as greatly as it would be in the event of a higher cost of capital. Said another way, with a low cost of capital, one can afford to wait longer for a payoff. If the cost of capital is high, a shorter term project which returns funds in the near term is preferred, because as payments stretch further and further into the future, their value is diminished by a high level of discounting.
A change in the cost of capital would never change the IRR rankings of two projects, as the cost of capital is irrelevant to IRR calculation
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