I read that IRR calculation assumes cash flows are reinvested at the IRR. The NPV method assumes that cash flows will be reinvested at the cost of capital.
I dont understand where is this cashflow being invested and if firm is using it to reduce their capital cost, how are they expecting to get a return on it? ( I mean its ur money and u keep it with yourself, how does that fetch u return?)
There are two schools of thought on how you should consider the interest rates used in NPV and IRR calculations:
- One believes that the discount rate is just that – a discount rate to arrive at the present value of the investment – and that once the investment generates a positive cash flow that money is no longer included in the investment; thus, the rate at which you can reinvest positive cash flows is not relevant.
- The other believes that the discount rate is the compound rate that the initial investment should earn for the entire duration of the project; i.e., that the interest that you earn when you reinvest positive cash flows is considered a return generated by the project itself. In that case, the reinvestment rate will affect the realized yield of the project.
When you study Fixed Income you’ll see this same issue raised in the context of yield to maturity (which is nothing more than an IRR): if the reinvestment rate is lower than the YTM, then the realized yield will be lower than the YTM, and vice versa.
I believe that the first school of thought has the stronger argument, but reasonable people can disagree.