Reinvestment Rate Assumption in NPV versus IRR

Banking & FinanceFinance ManagementGrowth & Empowerment

To check the feasibility of projects, investors and companies normally use the Net Present Value (NPV) and the Internal Rate of Return (IRR) methods. Each of these two techniques has different assumptions, including the assumption of reinvestment rate.

Generally, NPV doesn’t have a reinvestment rate assumption, while IRR does have it. The reinvestment rate assumption, therefore, changes the IRR’s overall outcome.

Net Present Value

NPV is tool companies use for capital budgeting decisions. NPV is calculated by determining the expected cash outflows and inflows for a project and discounting them with a discount rate. NPV has more inputs and flexibility in comparison to IRR. However, it requires more work and analysis to arrive at the final outcome.

The discount rate has many inputs such as cost of capital and risk of a project. The discount rate of NPV directly correlates with the risk the project has. When the NPV of a project is negative, it means the project will lose value; while when the NPV is positive, it means the project will gain value.

Internal Rate of Return

IRR shows the rate of return a company has to reach a break-even point.

  • When the IRR is higher than the required rate of return, then the project will create value.

  • An IRR lower than the required rate of return means the project will lose value.

Therefore, the investors must choose a project that has a rate of return higher than the required rate of return.

Reinvestment Rate Assumption

NPV and IRR have different basics when reinvestment rate assumption is considered.

  • NPV does not have a reinvestment rate assumption, so reinvestment will not change the final outcome of NPV of a project.

  • IRR does consider reinvestment rate assumption. The IRR assumes that the company will reinvest cash inflows at the rate of return for the entire lifetime of the project.

    • When the reinvestment rate is too high to be feasible, the IRR of the project will fall.

    • If the reinvestment rate is higher than the IRR’s rate of return, then the project will be feasible.

Considerations

It is notable that NPV is a better technique than IRR, but it also has more inputs and complex calculations. NPV is also better at comparing different projects at different time horizons. On the other hand, IRR is a quick way to measure the feasibility of investment.

There are two ways a company can adjust risk: the first is to adjust risk with cash flows and the second is to adjust the IRR after calculation of the risk premium.

raja
Published on 28-Oct-2021 12:04:42
Advertisements