The Controversial Reinvestment Assumption in IRR and NPV Estimates: New Evidence against Reinvestment Assumption

Abstract

The reliability of capital investment analysis is often questioned because of the controversy surrounding the assumption of reinvestment of the intermediate income in the estimation of IRR and NPV. A simulation study is conducted to test the validity of this assumption. The simulation involves a factual run ‘without reinvestment’ and a counterfactual run ‘with reinvestment’ as the introduced shock. The result provides sufficient evidence that there is no reinvestment of intermediate income in the IRR or NPV estimates. IRR or NPV only reflects the intrinsic value of the net benefits to recover the ‘return of and on capital’ invested. Instead, there is progressive divestment of capital invested during the life of the investment. The future value of the divested capital, if reinvested elsewhere at IRR as the rate, offsets the capital cost that is often confused as reinvestment. The result is consistent under both normal and non-normal cash flow projects. Obviously, text books dealing with capital investment analysis should move away from such an assumption. The current capital investment analysis using the IRR and NPV is, therefore, reliable. Also, the MIRR estimate that is based on reinvestment assumption must be critically reviewed along with other limitations. With reinvestment assumption, the MIRR collapses to IRR and becomes redundant.

Keywords: CBA and Capital Investment, Validity of Reinvestment Assumption, New Evidence

JEL Classification: D, D61, G, G31, O2, O22