Teaching about the reinvestment rate assumption and conflicts in Capital Budgeting

Sorin Tuluca

No 3906612, Proceedings of Teaching and Education Conferences from International Institute of Social and Economic Sciences

Abstract: Much has been written in finance textbooks and scholarly publications about the capital budgeting methods derived from Discount Cash Flow (DCF) models: Net Present Value (NPV), Internal Rate of Return (IRR), Modified Internal Rate of Return (MIRR) and Profitability Index (PI). However, there is a divergent understanding about the role of the reinvestment rate assumption in some of these models. In this paper I will discuss a number of issues regarding the assumption of the reinvestment rate and clarify its correct usage. This discussion will naturally lead to the Modified Internal Rate of Return as the only method where a reinvestment rate assumption makes sense. In addition, for the first time in the literature I will propose a method of determining if the NPV and MIRR will produce conflicting decisions in advance of the MIRR computation. The literature has a clear method to determine if the there is a conflict between NPV and IRR but no method for the NPV-MIRR conflict is described. Interestingly the Profitability Index will have a role in determining if the NPV and MIRR are in conflict. The paper is useful to all those who teach the topic of capital budgeting in corporate finance courses of any level.

Keywords: Capital Budgeting; reinvestment rate; conflict in ranking (search for similar items in EconPapers)
JEL-codes: G30 G31 (search for similar items in EconPapers)
Pages: 6 pages
Date: 2016-08
References: Add references at CitEc
Citations:

Published in Proceedings of the Proceedings of the 3rd Teaching & Education Conference, Barcelona, Aug 2016, pages 217-222

Downloads: (external link)
https://iises.net/proceedings/3rd-teaching-educati ... =39&iid=022&rid=6612 First version, 2016

Related works:
Working Paper: Teaching about the reinvestment rate assumption and conflicts in Capital Budgeting (2016)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:sek:itepro:3906612

Access Statistics for this paper

More papers in Proceedings of Teaching and Education Conferences from International Institute of Social and Economic Sciences
Bibliographic data for series maintained by Klara Cermakova ().