The Reinvestment Rate Assumption Fallacy for IRR and NPV

9 Pages Posted: 26 Dec 2017 Last revised: 10 Jun 2018

See all articles by Carlo Alberto Magni

Carlo Alberto Magni

Università degli studi di Modena e Reggio Emilia (UNIMORE) - School of Doctorate E4E (Engineering for Economics-Economics for Engineering)

John D. Martin

Baylor University - Department of Finance, Insurance & Real Estate

Date Written: December 19, 2017

Abstract

The mistaken notion that the internal rate of return (IRR) and net present value (NPV) contain reinvestment rate assumptions lingers in teaching materials and corporate practice. The fact is that there are no reinvestment rate assumptions built into, or implicit to, the computation and use of either the IRR or NPV. Cash flows thrown off by capital investments do not have to be reinvested and can be distributed to creditors, shareholders, or retained for future investment with no adverse effect on either the IRR or NPV. In this brief note, we first review the theoretical underpinnings of the rate of return assumption fallacy and offer two possible origins from the academic finance literature that may have been responsible for the reinvestment rate fallacy.

Keywords: NPV, IRR, reinvestment assumption, scale effects

JEL Classification: G00, G11, G12, G31

Suggested Citation

Magni, Carlo Alberto and Martin, John D., The Reinvestment Rate Assumption Fallacy for IRR and NPV (December 19, 2017). Available at SSRN: https://ssrn.com/abstract=3090678 or http://dx.doi.org/10.2139/ssrn.3090678

Carlo Alberto Magni (Contact Author)

Università degli studi di Modena e Reggio Emilia (UNIMORE) - School of Doctorate E4E (Engineering for Economics-Economics for Engineering) ( email )

Italy

John D. Martin

Baylor University - Department of Finance, Insurance & Real Estate ( email )

P.O. Box 98004
Waco, TX 76798-8004
United States
254-710-4473 (Phone)
254-710-1092 (Fax)

HOME PAGE: http://hsb.baylor.edu/html/martinj

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