Correct option is B
In capital budgeting, cash flows are assumed to be reinvested at certain rates depending on the method used to evaluate the investment. The three key rates considered are:
Discount Rate (A) – This is the rate used to discount future cash flows to their present value. The assumption is that cash inflows are reinvested at the same rate at which they are discounted.
Cost of Capital (C) – This represents the minimum return a firm expects from an investment. In methods like Net Present Value (NPV), the assumption is that cash flows are reinvested at the cost of capital.
Internal Rate of Return (E) – In IRR-based capital budgeting, it is assumed that cash flows are reinvested at the internal rate of return, which may be different from the cost of capital.
Thus, the correct answer includes A (Discount Rate), C (Cost of Capital), and E (Internal Rate of Return).
Information Booster:
Reinvestment Rate Assumptions in Capital Budgeting:
- Net Present Value (NPV) Method: Assumes reinvestment at the Cost of Capital (C).
- Internal Rate of Return (IRR) Method: Assumes reinvestment at the Internal Rate of Return (E), which can sometimes lead to unrealistic growth expectations.
- Modified IRR (MIRR): Overcomes the IRR assumption issue by assuming reinvestment at the Cost of Capital (C) instead.
- Discount Rate (A) is commonly used in NPV calculations to reflect the time value of money.
Additional Knowledge:
Market Rate (B) - The market rate fluctuates based on external economic factors. However, capital budgeting decisions are made using a firm's internal financing assumptions, not unpredictable market rates.
Riskless Rate (D) - The risk-free rate (often represented by government securities like Treasury bonds) is not a typical assumption in capital budgeting since firms take on risks with their investments.
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10 Questions
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