The Effect of Reinvestment Rate Assumption on NPV & IRR Calculations

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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. NPV does not have a reinvestment rate assumption, while IRR does. For IRR, the reinvestment rate assumption may change the outcome of the IRR.

Net Present Value

NPV is one of the tools companies use for capital budgeting purposes. Companies calculate NPV by determining expected cash inflows and outflows for a project and then discounting all of those cash flows with a discount rate. The advantage of NPV over IRR is that it has more inputs and more flexibility; however, it does require more work and estimates to perform the analysis. The discount rate has a number of inputs including cost of capital and the risk of a project. The discount rate directly correlates with the risk of a project. If the NPV of a project is negative, that means that the project will decrease value. If it is positive, that means that the project will help the company create value.

Internal Rate of Return

Companies use IRR to calculate the feasibility of a project by finding the rate of the return the project has to earn to break even. If the IRR is higher than the required rate of return, then that means that the project will create value. An IRR lower than the required rate of return decreases value. IRR has no discount rate or risk assumptions.

Reinvestment Rate Assumption

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. If this reinvestment rate is too high to be feasible, then the IRR of the project will fall. If the reinvestment rate is higher than the IRR's rate of return, then the IRR of the project is feasible.

Considerations

NPV is a more useful technique, but also more complicated with more inputs and assumptions. It is also a better tool for comparing different projects at different time horizons. The IRR technique is quicker for a company to calculate. The company can also adjust IRR for risk in two different ways: the company can risk adjust cash flows and can adjust the IRR after calculation for a risk premium.

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