​In which method of capital budgeting, cash flows are re-invested at the required rate of return?​

Correct option is A

Introduction:

The Net Present Value (NPV) method assumes that all future cash inflows generated by a project are reinvested at the required rate of return (also known as the discount rate or cost of capital).

• NPV involves discounting all future cash flows to their present value using the firm’s required rate of return.

• This method is based on the principle of time value of money, ensuring consistency in evaluating profitability.

• Reinvestment assumption is critical: NPV assumes that intermediate cash inflows are reinvested at the cost of capital, which is a realistic assumption, unlike the IRR method.

• It reflects the true value addition of a project to the shareholders' wealth.

This makes NPV a superior and more reliable capital budgeting method, especially when comparing projects with different cash flow patterns.

Information Booster:

• NPV = Present Value of Cash Inflows – Initial Investment.

• It assumes reinvestment of intermediate cash flows at cost of capital (required rate of return).

• Positive NPV indicates a value-generating project.

• NPV supports shareholder wealth maximization, which aligns with financial objectives.

• It is additive, meaning multiple project NPVs can be combined.

• More suitable for mutually exclusive project comparisons.

• Used widely in corporate financial decisions, especially under risk and return considerations.

  Additional Knowledge:
  

(b) Internal Rate of Return (IRR)

• Assumes that intermediate cash flows are reinvested at the IRR itself, which may be unrealistic, especially when IRR is unusually high or when project cash flows vary greatly.

• This leads to potential overestimation of project profitability.

(c) Profitability Index (PI)

• While PI is a relative measure derived from NPV (PI = Present Value of Cash Inflows / Initial Investment), it also assumes reinvestment at the required rate of return, like NPV.

• However, since PI is not the primary method but a derivative, the core reinvestment assumption is credited to NPV.

(d) Accounting Rate of Return (ARR)

• Based on accounting profits and book values, not cash flows.

• It does not account for time value of money.

• ARR does not involve reinvestment assumptions, making it the least reliable among capital budgeting tools.