Wednesday, February 17, 2010


Varying Opportunity Cost of Capital

Evaluation investments we have made a simple assumption that the opportunity cost of capital remains consistent over times. This may not be true in reality. If the opportunity cost of capital varies over time, the use of the internal rate of return (IRR) rule creates problems, as there is not a unique benchmark opportunity cost of capital to compare with internal rate of return (IRR).

There is no problem in using net present value (NPV) method when the opportunity cost of capital various over time. Each cash flow can be discounted by the relevant opportunity cost of capital.

It is clear that for each period there is a different opportunity cost of capital. With which of the several opportunity costs do we compare the IRR to accept or reject an investment project? We cannot compare internal rate of return (IRR) with any of these costs. To get a comparable opportunity cost of capital, we will have to, in fact, compute a weighted average of these opportunity costs, which is a tedious job. It is, however, much easier to calculate the net present value (NPV) with several opportunity costs.

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