What reinvestment rate assumptions are built into the NPV, IRR, and MIRR methods? Give an explanation for your answer.
For NPV, the reinvestment rate is the WACC. With this method, it is assumed that the cash flows received from the project will be reinvested at the WACC. The present value of the cash flows is then computed using WACC as a discount rate.
For IRR, the reinvestment rate is the IRR or the rate at which the project breakevens. In other words, the IRR is the rate at which the NPV of the project is 0. With IRR, it is assumed that the cash flows are reinvested at the IRR.
For MIRR, the reinvestment rate is the WACC. To find MIRR, first find the future value of the cash flows using WACC, then find the rate at which the future value of the cash flows would equal 0.
Recommended textbook solutions
A firm has a $100 million capital budget. It is considering two projects, each costing$100 million. Project A has an IRR of 20% and an NPV of $9 million; it will be terminated after 1 year at a profit of$20 million, resulting in an immediate increase in EPS. Project B, which cannot be postponed, has an IRR of 30% and an NPV of $50 million. However, the firm’s short-run EPS will be reduced if it accepts Project B because no revenues will be generated for several years. a. Should the short-run effects on EPS influence the choice between the two projects?
Discuss the following statement: If a firm has only independent projects, a constant WACC, and projects with normal cash flows, the NPV and IRR methods will always lead to identical capital budgeting decisions. What does this imply about the choice between IRR and NPV? If each of the assumptions were changed (one by one), how would your answer change?