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John Moffat.
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Forums › Ask ACCA Tutor Forums › Ask the Tutor ACCA FM Exams › Reinvestment assumption
Hi sir, can you explain the reinvestment assumption of IRR and reinvestment rate of NPV
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).
Should I only be aware of the fact that IRR assumes we reinvest at IRR and that NPV assumes we reinvest at the cost of capital?
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.