Sage-Tips

What reinvestment rate assumptions are implicitly made by the Net Present Value and Internal Rate of Return methods?

4. What reinvestment rate assumption does IRR implicitly make? The IRR method implicitly assumes reinvestment of all intermediate cash inflows at the IRR. This does not mean, however, that the firm can actually reinvest such cash inflows at the IRR.

What does the reinvestment assumption behind the IRR mean?

One of the most commonly cited limitations of the IRR is the so called “reinvestment rate assumption.” In short, the reinvestment rate assumption says that the IRR assumes interim cash flows are reinvested at the IRR, which of course isn’t always feasible.

What is reinvestment assumption?

A reinvestment rate assumption can be defined as the specific interest rate at which funds could be reinvested in order to take advantage of predicated fluctuations in the marketplace.

Does the IRR method implicitly assume a reinvestment rate?

It is correct to say that IRR implicitly assumes that the cash flows are reinvested at IRR itself. In the case of IRR, we are just finding the cutoff rate that equates the project’s discounted future cash flows to the initial outlay.

What is implicit reinvestment rate?

reinvestment rates are implicit… in the decision to use one or the other of the two. criteria and not to make any explicit estimate of the possible return on reinvestment. of intermediate cash flows received prior to the terminal date” (p. 908).

What reinvestment rate assumptions are built into the NPV?

Explanation. The NPV uses the cost of capital to discount the cash flows received from the project, and the method also assumes that these cash flows are reinvested at the same rate. The computation of the IRR assumes that the cash flows are discounted at the IRR and that the cash flows are reinvested at the IRR.

In what sense is a reinvestment rate assumption embodied in the NPV IRR and MIRR methods What is the assumed reinvestment rate of each method?

IRR has a reinvestment rate assumption, which assumes that the company will invest the cash flows at the IRR for the project’s life span. IRR will fall if the reinvestment rate is too rate. If the reinvestment rate is higher than IRR, IRR is feasible. Hence reinvestment rate is dependent upon the cost of capital.

In what sense is a reinvestment rate assumption embodied in the NPV IRR and MIRR methods?

What is reinvestment type?

Reinvestment is the practice of using dividends, interest, or any other form of income distribution earned in an investment to purchase additional shares or units, rather than receiving the distributions in cash.

What is reinvestment in bond?

Instead of making coupon payments to the investor, some bonds automatically reinvest the coupon paid back into the bond, so it grows at a stated compound interest rate. The exact amount depends on the interest rate earned by the reinvested payments and the time period until the bond’s maturity date.

Why do NPV and IRR have different reinvestment rate assumptions?

The two tools have different reinvestment rate assumptions. The NPV has no reinvestment rate assumption; therefore, the reinvestment rate will not change the outcome of the project. The IRR has a reinvestment rate assumption that assumes that the company will reinvest cash inflows at the IRR’s rate of return for the lifetime of the project.

What are the assumptions of the IRR rule?

The IRR rule assumes that intermediate cash flows from the project get reinvested at the IRR. Implicit is the assumption that the firm has an infinite stream of projects yielding similar IRRs.3 NPV and PI assume reinvestment at the discount rate. IRR assumes reinvestment at the internal rate of return.4

How does the IRR affect the Project’s IRR?

The IRR has a reinvestment rate assumption that assumes that the company will reinvest cash inflows at the IRR’s rate of return for the lifetime of the project. If this reinvestment rate is too high to be feasible, then the IRR of the project will fall.

What are the assumptions of net present value and internal rate of return?

Companies commonly use the net present value and internal rate of return techniques to better understand the feasibility of projects. Each technique has different assumptions, including the assumption regarding the reinvestment rate.