Discount Rate Higher for Leveraged Deals?

Question

I am looking at two proformas for one investment and noticed the following:

1. The discount rate is 10 percent for an un-leveraged investment on the proforma and yields an IRR of 11 percent.

2. The discount rate is 15 percent for a leveraged investment on a proforma and yields an IRR of 69 percent.

Question: Why is the discount rate higher on a leveraged investment than that of an un-leveraged investment?
Question: Why do the unleveraged deal show a lower discount rate then the leveraged deal?

Thanks.

Steve Schow · Answer

one thing I don't understand is how you're using a discount rate in the calculation of IRR.  ??  My understanding is the discount rate is used to calculate NPV and PI.  The IRR calculation only factors in cash flows over time to result in a final value which *IS* the discount rate.
            
            MIRR allows you to specify a finance rate and reinvestment rate...neither of which is the same as a discount rate.
            
In answer to your other question, it makes sense to me that a leveraged investment will have a higher ROI then an unleveraged investment.  The discount rate is, for the most part, the minimum acceptable ROI that will make the deal doable.

Anwell T. · Answer

There are several possibilities, depending on the circumstances.  I would venture that the discount rate for the leveraged investment is higher in order to reflect the additional risk.  If you decide to use the opportunity cost as a proxy for the discount rate, than it would make sense that a similar investment of similar risk would require a higher rate of return for the leveraged investment as well.  Be careful when using IRR in that there are some mathematical peculiarities which can yield multiple answers.  You could try using several different modified forms of the IRR though I prefer to use Net Present Value and a Profitability Index.