The Reinvestment Rate Assumption Fallacy for IRR and NPV

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