Reinvestment assumption

This is only relevant if we are choosing between two or more projects.

We always choose the one with the highest NPV and this might not be the one with the higher IRR. For example, investing $100,000 in a machine that gave a return of 10% a year for only 4 years, but not be as good at investing in a machine that gave a return of 9% a year for 20 years, because although the return each year is slightly lower we would get it for much longer.

It would only be valid to choose the one with the highest IRR if we assumed that all returns from the machines could be reinvested so as to get the same return. So then the first machine in my example would effectively get getting us 10% a year for ever, whereas the second one would only be getting us 9% per year for ever.

I do again explain this in my free lectures (although it is not often relevant in the exam and when it is it is only with regard to theory questions and not calculations).

You only need to be aware that the problem of comparing investments on the basis of their IRR’s is that it would only be valid if we assume that returns are reinvested at the IRR (and, of course, a problem with IRR’s in general is that a project can have more than one IRR).

However, again, calculations on both of these are not relevant for the exam.