Opportunity Cost: Essential for Smart IRR Investment Decisions

Imagine you have some money to invest, say ten thousand dollars. You’re considering two different projects. Project A promises a fantastic internal rate of return, or IRR. Think of IRR as the project’s own built-in interest rate, like the annual percentage yield on a savings account. Let’s say Project A boasts an IRR of 15 percent. Sounds pretty good, right?

Now consider Project B. Project B has a slightly lower IRR, perhaps 12 percent. At first glance, you might be tempted to jump straight for Project A, the one with the higher IRR. It’s like seeing two deals, and naturally, you might gravitate towards the one that seems to offer the bigger percentage return.

However, this is where the concept of opportunity cost of capital becomes absolutely vital. Opportunity cost of capital is essentially the return you could reasonably expect to earn on an investment of similar risk, if you chose to invest elsewhere. It’s like asking yourself, “What else could I do with my money that’s just as safe or risky as these projects?”

Think about it this way: If you put your ten thousand dollars into a standard savings account or a government bond, you might earn a return of, let’s say, 5 percent. This 5 percent return represents a baseline, a readily available alternative. This 5 percent is a simplified example of your opportunity cost of capital in this very basic scenario.

In the real world, determining the opportunity cost of capital is a bit more nuanced. It’s not just about savings accounts. It’s about considering investments of similar risk. If Project A and Project B are considered relatively risky ventures, you should compare their IRRs not just to each other, but to the returns you could get from other investments that carry a similar level of risk. These similar risk investments might include stocks, bonds, or even other types of business projects.

Let’s say, after doing your research, you discover that investments with similar risk profiles to Project A and Project B typically yield an average return of 10 percent in the current market. This 10 percent becomes your opportunity cost of capital for these projects. It represents what you’re giving up by choosing to invest in either Project A or Project B instead of investing in these other comparable alternatives.

Now, let’s revisit our projects. Project A has an IRR of 15 percent, and Project B has an IRR of 12 percent. Your opportunity cost of capital is 10 percent.

When you apply the IRR rule, you’re essentially asking: “Is the project’s IRR higher than my opportunity cost of capital?” If a project’s IRR is higher than your opportunity cost of capital, it suggests the project is offering a better return than what you could reasonably expect to get elsewhere for a similar level of risk. In that case, the IRR rule generally says, “Go for it!”

So, for Project A, with its 15 percent IRR, it’s indeed higher than your 10 percent opportunity cost of capital. This looks good. For Project B, with its 12 percent IRR, it’s also higher than your 10 percent opportunity cost of capital. This also looks good.

However, without considering the opportunity cost of capital, you might simply choose Project A because its IRR is higher than Project B’s. But, by considering the opportunity cost of capital, you understand that both projects are actually worthwhile investments because they both exceed the return you could get elsewhere at a similar risk level.

The crucial point is that the IRR rule isn’t meant to be used in isolation. You can’t just pick the project with the highest IRR without considering what other options are available. The opportunity cost of capital provides that vital benchmark. It acts as a hurdle rate. A project’s IRR needs to clear this hurdle to be considered a good use of your investment capital. If a project’s IRR is below your opportunity cost of capital, it means you’d be better off investing your money in those other, comparable alternatives, even if the project itself seems to offer a positive return in isolation. Ignoring opportunity cost can lead you to invest in projects that look good on paper with a high IRR, but are actually underperforming compared to other readily available investment opportunities of similar risk. Therefore, always remember to compare a project’s IRR to your opportunity cost of capital to make truly informed and value-maximizing investment decisions.