NPV Mirr IRR Cost of Capital

Capital Budgeting

Reinvestment rates are an embodied assumption in the NPV, IRR and MIRR methods because in each of those methods, the cost of capital for the company is typically used as the discount rate. The cost of capital for the company is going to be comprised of the different elements of the capital structure, but in each of those the reinvestment rate is a key factor. It is assumed that the cost of capital is the reinvestment rate under each of these methods, and this assumption introduces the potential for error.

The assumed reinvestment rate of MIRR is the cost of capital, but this is problematic for a couple of reasons. The first is that this does not take into account project-specific risk (Damodar, n.d.). Each project has its own risk. Thus, the reinvestment rate should not necessarily be the same rate that is used in an NPV, IRR or MIRR calculation. The reality is that the reinvestment rate of return could be quite different. The firm's cost of capital could change over time, or the project might vary substantially from the normal business that the firm conducts, and therefore have a significantly different risk characteristic.

The second reason why this assumption is problematic is that ultimately the reinvestment is not relevant to the project. Once the capital is returned from the project, any reinvestment that is done would be subject to its own NPV, IRR, or MIRR calculation. Reinvestment should not be considered incremental to the project at hand, unless the funds are to be reinvested directly back into that project.

The assumed return under IRR, which is the IRR rate, is also problematic. NPV assumes return at the NPV rate. The problems are the same as above, however, in that there can be a discrepancy between this rate and the actual rate at which money is returned, and that discrepancy can skew a project's value when performing these calculations.

3. NPV is regarded as the most theoretically sound technique for a couple of reasons. The base calculation of NPV and IRR is the same one, the difference being that IRR is a percentage return, and NPV is the dollar value. The point at which the IRR becomes higher than the discount rate is also the point at which the NPV becomes positive. However, NPV takes into account the dollar value of the transaction. This is more robust because a company typically has finite resources. When choosing between projects that are mutually exclusive, it is important to choose the project that returns the greatest dollar value to the shareholders. If a project with a higher IRR is chosen, but it has a lower dollar value and the result is that some money sits on the sidelines, the lack of return for that money has to be taken into consideration, and that is precisely what NPV does in comparison to IRR.

While MIRR offers some improvement over IRR in terms of assuming reinvestment at the cost of capital, that does not affect the relationship between MIRR and NPV -- NPV is superior, and for the same reasons that it is better than IRR. It should be noted that NPV is also superior to other methods, such as payback period, because the payback period method ignores cash flows that occur after payback, and those could sometimes be substantial.