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Tempted by a project with high internal rates of return? Better check those interim cash flows again.
The McKinsey Quarterly, McKinsey & Co.
October 20, 2004
There is no reinvestment rate assumption in IRR, it is simply the interest rate that makes the NPV equal to zero. In fact, the MIRR makes matters worse since the rate of return is now not internal to the project. Here are 2 questions: 1) Does the YTM calculation of a bond assume reinvestment of the intermediate coupons? No. But the YTM calculation of a bond is nothing more than the IRR of the bond. 2) I have a project that costs $100 today and returns $10 in one year and $110 in 2 years. What is the IRR of the project? It is easy to confirm that the IRR is 10%. Now suppose I spend the $10 on pizza in one year. Does this change the IRR? No. Now suppose I take the $10 and reinvest it in another project that returns 2%. Does that change the IRR of the original project? No. The fact that the $10 was taken out of the original project and invested in another project is irrelevant. The return on the 2nd project has nothing to do with the return on the first project since the IRR only deals with the "return interal to the project" (rearrange to IRR if you wish), not what is done with the intermediate cash flows.
Posted by Joe Smolira | November 16, 2009 05:09 pm
Dear All Kindly consider the following: 1. For a long term project is the cost of capital going to remain same?? 2. Isn't cost of capital dependent upon its mix of equity and debt? 3. Does equity not factor in the higher rate for higher risk? 4. 1,2,&3 above inherently build in the higher returns expected from a riskier project (so the room for disparity should not be so huge between the expected returns and the actual returns earned; in case it is so...should one not revisit the RADR assumptions ?? 5. Can the returns be supernormal for a wider spectrum of investment opportunities (..here read "project") If yes lets revise the CAPM and other normalisation models. 6. An industry builds up the investment portfolio across a spectrum of low to high risk areas, with the variation brought in by its cash flow position and strategic positoining. 7. In light of the above when we calculate IRR; we are essentially considering a "risk chunk" and in that particular chunk the industries usually have a turnaround of the cash flows (if we talk of oil and gas industry this "risk chunk" can be exploratory projects in a high risk high gain terrain). Hence the clinical observation of lack of reinvestment opportuinity reflects the view more of a short sighted accountant rather than the view of a strategically forward looking CEO. 8.In addition to the above however, there should be a due dillegence regarding the long term indicators 9. I may be grossly wrong...so dont take it to your heart.. Best regards
Posted by NAVNEET JAIN | September 15, 2009 06:54 am
I must say, I agree with Mr McClendon here... If I am not mistaken, IRR just calculate the rate where NPV = 0, so it doesn't actually take into consideration what you do with the positive cashflow you receive from the project.
Posted by Leonard Buntaran | May 03, 2009 11:19 am
Dear Troy The debate on the necessity of reinvestment of cashflows seems to be never ending! This is the 21st Century and yet each day authors still post conflicting statements. Please post your views and matrix and settle this issue. Regards
Posted by Gordon Matthews | August 14, 2008 04:34 pm
I have been a Senior Instructor for the Commercial Investment Institute (CCIM) for 26 yeaers and I say your statements are wrong and inaccurate. The IRR makes no assumptions about reinvestment of cash flows. Reply and I'll send you a matrix to prove it.
Posted by Troy McClendon | August 09, 2008 08:20 pm
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