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The Real Reinvestment Rate Assumption as a Hidden Pitfall

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  • Mária Illés

    (University of Miskolc)

Abstract

The paper explores a few hidden problems of the reinvestment rate assumption. The automatism of net present value method creates and applies a very special reinvestment rate assumption. This assumption does not disturb the evaluation of investment projects with orthodox cash flow patterns. However, in the case of unorthodox cash flow patterns, automatism constructs a serious mistake in the calculations. In this case, the net present value provides wrong information about the economic efficiency. However, according to the general academic opinion, the net present value method is suitable for evaluation in the case of unorthodox cash flow patterns as well, as there can be only one net present value as opposed to the opportunity of several internal rates of return. The paper sets out to prove that this way of evaluation is wrong, and works out a solution based on the real economic basis.

Suggested Citation

  • Mária Illés, 2016. "The Real Reinvestment Rate Assumption as a Hidden Pitfall," Theory Methodology Practice (TMP), Faculty of Economics, University of Miskolc, vol. 12(01), pages 47-60.
    • Handle: RePEc:mic:tmpjrn:v:12:y:2016:i:01:p:47-60
    as

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    File URL: http://tmp.gtk.uni-miskolc.hu/volumes/2016/01/TMP_2016_01_06.pdf
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    References listed on IDEAS

    as
    1. Carlson, C. Robert & Lawrence, Michael L. & Wort, Donald H., 1974. "Clarification of the reinvestment assumption in capital analysis," Journal of Business Research, Elsevier, vol. 2(2), pages 201-208, April.
    2. Dudley, Carlton L, Jr, 1972. "A Note on Reinvestment Assumptions in Choosing Between Net Present Value and Internal Rate of Return," Journal of Finance, American Finance Association, vol. 27(4), pages 907-915, September.
    3. Stephen Keef & Melvin Roush, 2001. "Discounted cash flow methods and the fallacious reinvestment assumption: a review of recent texts," Accounting Education, Taylor & Francis Journals, vol. 10(1), pages 105-116.
    4. Ezra Solomon, 1956. "The Arithmetic of Capital-Budgeting Decisions," The Journal of Business, University of Chicago Press, vol. 29, pages 124-124.
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    More about this item

    Keywords

    reinvestment rate assumption; net present value; internal rate of return; orthodox and unorthodox cash flow pattern; ranking; aggregate capital needs;
    All these keywords.

    JEL classification:

    • M21 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Business Economics - - - Business Economics
    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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