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CA Intermediate · Financial Management and Strategic Management · Investment Decisions

Under the Internal Rate of Return method, the implicit assumption about the intermediate cash inflows generated by a project is that they are reinvested at:

The IRR method implicitly assumes intermediate cash inflows are reinvested at the project's own IRR. This contrasts with NPV, which assumes reinvestment at the cost of capital. The difference can make IRR overstate returns for high-yield projects and can cause conflicting rankings of mutually exclusive projects.

  1. Athe firm's cost of capital
  2. Bthe project's own IRRCorrect
  3. Cthe risk-free rate of return
  4. Dzero return, i.e., they are held as idle cash

Explanation

The IRR method implicitly assumes that interim cash inflows can be reinvested at the IRR itself. The NPV method assumes reinvestment at the cost of capital, which is more realistic, especially for high-IRR projects. This difference is a key reason NPV and IRR can rank mutually exclusive projects differently.

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