Question

If the required rate of return for a project increases from 10% to 12%, the impact on the IRR and the NPV would be:

a. IRR would increase and NPV would decrease

b. IRR would stay the same and NPV would decrease

c. IRR would stay the same and NPV would increase

d. IRR would increase and NPV would increase

e. None of the above

It was said that IRR would stay the same. Please explain why, and please explain why NPV would either increase or decrease.

Answer 1

The correct answer is "b" : IRR would stay the same and NPV would decrease

Reason :

a) Why NPV decreases : NPV decreases because higher the discounting rate, lower is the value. This is because an increase in the discount rate decreases the present value factor and hence the present value as well.

If I were to talk in non-mathematical terms, this is because I need to invest less today to get the same amount that I could get by investing more at lower interest rates.

b) Why IRR stays the same : IRR will stay the same because IRR dosen't depend on the discount rate. Instead IRR is a discount rate itself that causes the project to break even, i.e., where the net present value of cash inflows are equal to net present value of cash outflows.