Could someone explain the following: It is sometimes siad that NPV implicitly assumes that project cash flows can be reinvested at the discount rate used to calculate NPV. If we were to rank projects by their IRRs, we would be implictly assuming that project cash flows could be reinvested at the project’s IRR. This is from Kaplan Capital budgeting page 25.
With NPV, you are using an interest rate to calculate a present value. The NPV calculatio n assumes that you reinvest all interim cash flows at the original interest rate to get the NPV answer. With IRR, you are calculating what interest rate makes the present value of the series of cash flows equal to zero. The IRR calculation assumes that all reinvestments are made at the IRR to come to the NPV of zero.
When the calculated IRR is higher than the true reinvestment rate for interim cash flows, the measure will overestimate (sometimes by a large amount), the annual equivalent return from the project. The IRR formula assumes that the company has additional projects, with equally attractive prospects, in which to invest the interim cash flows. In this case, the IRR calculation implicitly takes credit for these additional projects. Calculations of net present value (NPV), by contrast, generally assume only that a company can earn its cost of capital on interim cash flows, leaving any future incremental project value with those future projects.
^I prefer IsleSea’s explanation
Understood. Thanks.