Intermediate cash inflows are assumed to be reinvested at what rate under the NPV method?

Correct option is B

The Net Present Value (NPV) method assumes that intermediate cash inflows (cash flows received during the project's lifetime) are reinvested at the cost of capital or the discount rate used in the NPV calculation. This assumption aligns with the fundamental principle of NPV, which discounts future cash flows at the firm's required rate of return, representing the minimum return expected by investors.

• The cost of capital reflects the company's financing costs and opportunity cost of funds.

• NPV uses this rate to determine whether an investment will generate value over and above its cost.

• Since firms typically reinvest cash inflows in projects that yield at least their cost of capital, this is a reasonable assumption.

• This reinvestment assumption differs from IRR, which assumes reinvestment at the project's IRR, potentially leading to misleading results in some cases.

Information Booster:

• Cost of capital is also known as the discount rate or hurdle rate in NPV calculations.

• The reinvestment assumption at the cost of capital ensures a more realistic estimate of profitability compared to the IRR method.

• If NPV is positive, the project is expected to generate value above the cost of capital, making it a good investment.

• The cost of capital is typically calculated as a weighted average cost of capital (WACC) when both debt and equity financing are involved.

• Companies use NPV for capital budgeting decisions to determine the feasibility of long-term investments.

Additional Knowledge:

1. IRR (Internal Rate of Return):

   • The IRR method assumes that intermediate cash inflows are reinvested at the IRR itself, which may be unrealistic.

   • In many cases, the IRR assumption leads to overestimated returns compared to actual reinvestment opportunities.

   • Unlike NPV, IRR can sometimes result in multiple solutions for projects with unconventional cash flows.

2. MIRR (Modified Internal Rate of Return):

   • MIRR corrects the unrealistic reinvestment assumption of IRR by assuming reinvestment at the cost of capital instead. 

   • It provides a more accurate measure of project profitability compared to IRR.

   • However, MIRR is a separate capital budgeting method, not directly used in the NPV method.​
     

3. Repo Rate:

   • The repo rate is the rate at which central banks lend money to commercial banks for short-term liquidity needs.

   • It has no direct connection to project reinvestment assumptions in NPV analysis.

   • The repo rate fluctuates based on monetary policy decisions and is not used for capital budgeting purposes.​