Level 1 CFA® Exam: IRR vs Cost of Capital

CFA exam review / IRR vs Cost of Capital

This blog post was created as a part of the CFA exam review series to help you in your level 1 exam revision, whether done regularly or shortly before your CFA exam.

How CFA Exam Questions Can Fool You

Very often in questions related to capital budgeting (both in the QM and CF sections of the CFA exam) the cost of capital is given, even though you are only asked to compute the IRR. In such questions, the cost of capital is a distractor.

However, in questions that require decision-making based on the IRR criterion (i.e., whether a company should undertake a project or not), the cost of capital has to be taken into consideration. Namely, we need to compare it with the calculated IRR.

Remember: The IRR is one of the possible discount rates (the one for which the NPV is 0). It does not depend on any other discount rate (like the cost of capital) and no other discount rate is needed to compute it.

Cost of Capital as a Distractor

Have a look at two examples illustrating the problem of cost of capital given as a distractor.

Example 1:

Mark, a financial manager, gathered the following data about a project:

The opportunity cost of capital is equal to 20%. Mark would like to evaluate the profitability of the project using the internal rate of return rule. What is the value of the IRR?

• A. 20.00%
• B. 21.85%
• C. 39.22%

Answer: B is correct.

CFA exam calculator CF and IRR worksheets:
Press [CF] to access the Cash Flow worksheet
Press [2ND] [CLR WORK] to clear the CF worksheet
CF0=-50,000
C01=-15,000
F01=1
C02=13,000
F02=1
C03=42,500
F03=1
C04=40,000
F04=1
C05=32,000
F05=1
Then, press [IRR] and [CPT].

B is correct because IRR = 21.85%.

Cost of Capital as a Necessity

Example 2:

Mark, a financial manager, gathered the following data about a project:

The opportunity cost of capital is equal to 20%. Mark would like to evaluate the profitability of the project using the internal rate of return rule. Which of the following statements is most likely correct?

• A. The financial manager should accept the project.
• B. The financial manager should not accept the project.
• C. Given the cash flows of the project, it is impossible to compute the internal rate of return explicitly.

Answer: A is correct.

To make the decision, we have to compute the internal rate of return (we have done it in Example 1) and compare it with the cost of capital (20%). So, answer A is correct because IRR equals 21.85% and it is higher than the cost of capital.

As you can see, even though the cost of capital is superfluous in Example 1 (and its presence can be somehow misleading), it is essential to do Example 2 correctly.
BTW, do you know how one can get to the incorrect answer C (39.22%) of Example 1? If yes, please share it with others in the comments below :)

LAST UPDATE: 7 Nov 2023