Question

If the hurdle rate used to discount a stream of cash flows is raised, the IRR of the cash stream will:

A) always increase
B) always decrease
C) not change
D) increase if the NPV is negative or decrease if the NPV is positive

Answer 1

The IRR of a cash stream remains unchanged when the hurdle rate used to discount the stream of cash flows is raised; instead, it's the NPV that decreases due to the higher discount rate.

Step-by-step explanation:

If the hurdle rate used to discount a stream of cash flows is raised, the Internal Rate of Return (IRR) of the cash stream will not change. The IRR is a discount rate that makes the net present value (NPV) of all cash flows equal to zero. It is inherent to the cash flows and does not vary with changes in the hurdle rate. Instead, what changes is the NPV of the investment: as the hurdle rate, which is the minimum acceptable rate of return on an investment, is increased, the present value of future cash flows is discounted at a higher rate, leading to a lower NPV.

If a bond pays fixed dollar payments determined by an 8% interest rate, and the market interest rate rises to 11%, the actual dollar payments do not change, but their present value, now discounted at the higher interest rate, will be lower.