BUS202: Principles of Finance

NPV and PI assume reinvestment at the discount rate, while IRR assumes reinvestment at the internal rate of return.

TERM

• Weighted average cost of capital

  The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets.
  
  

Reinvestment Rate

To some extent, the selection of the discount rate is dependent on the use to which it will be put. If the intent is simply to determine whether a project will add value to the company, using the firm's weighted average cost of capital may be appropriate. If trying to decide between alternative investments in order to maximize the value of the firm, the corporate reinvestment rate would probably be a better choice.

NPV Reinvestment Assumption

The rate used to discount future cash flows to the present value is a key variable of this process. A firm's weighted average cost of capital (after tax) is often used, but many people believe that it is appropriate to use higher discount rates to adjust for risk or other factors. A variable discount rate with higher rates applied to cash flows occurring further along the time span might be used to reflect the yield curve premium for long-term debt.

Another approach to choosing the discount rate factor is to decide the rate that the capital needed for the project could return if invested in an alternative venture. Related to this concept is to use the firm's reinvestment rate. Reinvestment rate can be defined as the rate of return for the firm's investments on average. When analyzing projects in a capital constrained environment, it may be appropriate to use the reinvestment rate, rather than the firm's weighted average cost of capital as the discount factor. It reflects opportunity cost of investment, rather than the possibly lower cost of capital.

PI Reinvestment Assumption

Profitability index assumes that the cash flow calculated does not include the investment made in the project, which means PI reinvestment at the discount rate as NPV method. A profitability index of 1 indicates break even. Any value lower than one would indicate that the project's PV is less than the initial investment. As the value of the profitability index increases, so does the financial attractiveness of the proposed project.

IRR Reinvestment Assumption

As an investment decision tool, the calculated IRR should not be used to rate mutually exclusive projects but only to decide whether a single project is worth the investment. In cases where one project has a higher initial investment than a second mutually exclusive project, the first project may have a lower IRR (expected return) but a higher NPV (increase in shareholders' wealth) and, thus, should be accepted over the second project (assuming no capital constraints).

IRR assumes reinvestment of interim cash flows in projects with equal rates of return (the reinvestment can be the same project or a different project). Therefore, IRR overstates the annual equivalent rate of return for a project that has interim cash flows which are reinvested at a rate lower than the calculated IRR. This presents a problem, especially for high IRR projects, since there is frequently not another project available in the interim that can earn the same rate of return as the first project.

When the calculated IRR is higher than the true reinvestment rate for interim cash flows, the measure will overestimate–sometimes very significantly–the annual equivalent return from the project. This makes IRR a suitable (and popular) choice for analyzing venture capital and other private equity investments, as these strategiesusually require several cash investments throughout the project, but only see one cash outflow at the end of the project (e.g., via IPO or M&A).

When a project has multiple IRRs, it may be more convenient to compute the IRR of the project with the benefits reinvested. Accordingly, MIRR is used, which has an assumed reinvestment rate, usually equal to the project's cost of capital.