What is the difference between IRR and the discount rate? For example: with regards to the NPV profiles of two projects, the crossover rate can be best described as the discount rate at which the two projects have the same NPV. Can we use IRR in the place of discount rate in the problem above or is that an incorrect use to the term. Why? Additionally, what do the horizontal and vertical axis represent in an NPV profile? Thank you!
The internal rate of return is the rate that makes the Net Present Value of a project equal to zero. The IRR is a rate independent of any external factors, that causes all of the cash inflows be equal to the cash outflows. That said, its called an INTERNAL rate of return because it only has to do with the cash flows relevant to the project. It has nothing to do with prevailing interest rates in any economy. The discount rate is a generic term for any rate that is determined subjectively or objectively, to discount future cash flows with. No, you can’t use the IRR in place of the discount rate. If you read your “problem”, which is actually just a factual statement, you’ll see that the crossover point is the calculated discount rate at which the two projects have the same profitability. This does not have anything to do, really, with the IRR. The project may have (and probably do have) different IRR’s at the crossover point. In your “problem”, you’re trying to compare two projects that have different IRRs and different NPVs. As you should know, when comparing two projects, the NPV and the IRR may tell you different things. You choose the one with the higher NPV. An NPV profile just illustrates this. In an NPV profile, the NPV is on the Y axis, discount rates on the X.
thanks for clearing that up, kkny, you explained it very clearly.