Which method assumes that the intermediate cash inflows are reinvested at the cost of capital?

Comparing NPV and IRR Techniques

Conflicting rankings between two or more projects using NPV and IRR sometimes occurs because of differences in the timing and magnitude of cash flows. This underlying cause of conflicting rankings is the implicit assumption concerning the reinvestment of intermediate cash inflows—cash inflows received prior to the termination of the project. NPV assumes intermediate cash flows are reinvested at the cost of capital, while IRR assumes that they are reinvested at the IRR. The correct approach to use is the NPV approach as a result. However, in most cases other than those noted below the IRR approach will produce the same result as the NPV approach.

Cases where NPV and IRR Can Differ

1. Mutually Exclusive Projects

This is the case where you are deciding between two projects

In this case, Project 1 generates most of its value early in the life of the project. Project 2 has large positive cash flow in later periods so most of its value comes at the end of project.  The IRR tells you that Project 1 is always a better project but this is only true at higher discount rates. As you can see from the NPV values and the graph, Project 2 is better at low discount rates because the delayed cash flows are more valuable when discount rates are low.

2. Nonconventional Projects

Many projects do not fit the traditional profile of paying out cash flows in early periods and receiving cash back in later periods. Some projects you receive money in early years and pay it back in later periods. In other projects, there may be cycles of positive and negative projects. Consider the case where you can continue to use an existing plant that is nearing the stage where it must be retrofitted to meet environmental standards at the end of three years and then you have to replace part of equipment after 6 years and after 8 years versus building a new plant. The older plant will generate more cash flows early but then have big negative cash flows at times during the middle years. In these cases, you can actually have multiple IRRs if there are enough changes in the sign of the cash flows. The NPV calculations will always give you the correct answers but the IRR will not.

Which one of the following methods of Capital Budgeting assumes that cash-inflows are reinvested at the project’s rate of return ?

1. Net Present Value
2. Accounting Rate of Return
3. Internal Rate of Return
4. Discounted Pay Back Period

Answer (Detailed Solution Below)

Option 3 : Internal Rate of Return

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Capital budgeting is a process used to determine whether an organization's long-term investments are worth the funding of cash through the firm's capitalization structure. It is a method of estimating the financial ability of capital investment over the lifespan of the investment.

Capital budgeting methods include Net Present Value, Accounting Rate of Return, Internal Rate of Return, Discounted Payback Period, Payback Period, Profitability Index.

Internal Rate of Return:

• It is the discount rate that makes the Net Present Value equal to zero.
• That means in this method discounted cash inflows are equal to discounted cash outflows.
• As long as the initial investment is a cash outflow and the leading cash flows are all inflows, the Internal Rate of Return method is accurate.
• This method assumes that cash-inflows are reinvested at the project's Internal Rate of Return.

Therefore, the Internal Rate of Return is a method of Capital Budgeting that assumes cash-inflows are reinvested at the project’s rate of return.

Net Present Value (NPV):

• The Net Present Value is the amount by which the present value (PV) of the cash inflows exceeds the present value of the cash outflows.
• On the contrary, if the present value of the cash outflows exceeds the present value of the cash inflows, the Net Present Value is negative.
• Therefore, NPV = PV of cash inflows - PV of cash outflows.
• Investment plans are accepted when NPV is positive and rejected when NPV is negative.

Accounting Rate of Return (ARR):

• It is a financial ratio that looks at the total accounting return for a project to check if it meets the target return.
• ARR is a percentage return and does not take into account the time value of the money.
• It calculates the return generated from the net income of proposed capital investment.

Discounted Payback Period: 

• The Payback period does not take into account the time value of money due to which this method was created.
• This method discounts the future cash flows back to their present value so that the investment and the sources of cash flows can be compared at the same time period.
• The discount rate for a company may represent its cost of capital or the potential rate of return from an alternative investment.

Last updated on Sep 21, 2022

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Which of the following capital budgeting methods assumes that intermediate cash inflows are reinvested at the minimum acceptable rate of return?

What capital budgeting method assumes that funds are reinvested at the company's cost of capital?

Which of the following methods assumes that cash flows are reinvested at the IRR?

Under Which method cash flow of each year is reinvested?