Pick a Rate, but Not Just Any Rate
You have two good ways to choose the discount rate you apply to future cash flows in the NPV method or the hurdle rate you use for comparison with the internal rate of return:
1. You can use the opportunity cost.
2. You can use your cost of capital—or, more properly, your incremental cost of capital.
Let’s examine each of these methods.
Using the Opportunity Cost
In general in investment analysis, the opportunity cost is the return you could earn on the next-best investment. Here, “next-best investment” refers to one you could actually make and earn that return on. “Opportunity cost” means the cost of forgoing the opportunity.
One good way to think of opportunity cost is to use the rate you would get ...