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CFA Level I · CFA Level I Exam · Capital Investments and Capital Allocation

The reinvestment rate assumption that underlies the NPV and IRR methods is best described as:

NPV assumes interim cash flows are reinvested at the cost of capital, while IRR assumes reinvestment at the project's own IRR. The IRR assumption can be unrealistic for high-IRR projects, which helps explain why the two rankings can conflict and why NPV is preferred.

  1. ANPV assumes reinvestment at the IRR; IRR assumes reinvestment at the cost of capital
  2. Bboth assume reinvestment at the cost of capital
  3. CNPV assumes reinvestment at the cost of capital; IRR assumes reinvestment at the IRRCorrect

Explanation

NPV implicitly reinvests interim cash flows at the opportunity cost of capital, which is realistic. IRR implicitly reinvests at the project's own IRR, which can be unrealistically high. This is why IRR can mislead when rankings conflict.

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