Discounted Cash Flow With Explicit Reinvestment Rates: Tutorial and Extension

Abstract

Academicians have demonstrated the superiority of the Net Present Value (NPV) method for capital budgeting decisions for the value maximizer. Unfortunately, practitioners do not exhibit the same fervor for theoretical purity that academics do. Specifically, numerous surveys of capital budgeting practices show that the most commonly used discounted cashflow (DCF) method among practitioners is the Internal Rate of Return (IRR). Theorists have shown that the IRR is an accurate method for typical capital budgeting cases, giving proper accept or reject solutions; nevertheless, in some cases the IRR solution is inferior to the NPV solution. Thus, theorists favor the NPV in research and class endeavors. Yet, decision makers tend to ignore the plea of NPV's higher level o f "rigor" in favor of the IRR's "more intuitive appeal."Because o f the exceptional cases and perhaps to bring academicians and practitioners closer, many have undertaken to improve the IRR by creating various DCF methods that give answers in the form of yields. Not all of these creations have met the demands of logical consistency; not all have had clear focus on what one must do to make a rational capital budgeting decision; and most have too much of an ad hoc flair to be considered legitimate pedagogically. Many of these new methods are not in the finance literature and thus may have escaped notice; therefore, a critical review of some of these methods is the second section of the paper.The criticisms of existing yield-based methods are based on a theoretical framework for NPV, set up in the paper's first section as a standard for comparison of other models presented. Then assumptions are relaxed to accommodate pragmatic decision-making. This is done to demonstrate how NPV and yield-based methods deal with the changed environment. The third section is the paper's primary purpose. It sets forth eight criteria essential for a yield-based DCF methods to be a valid substitute for NPV. These criteria require that the yield-based method: . 4. 5. 6.7. 8.gives the same accept/reject decision as NPV for every project; maintains risk-equivalence with the firm's typical operations so that it may be compared to the marginal cost of capital; is consistent with the idea that in the long run the marginal return on projects approaches equilibrium with the marginal cost of capital; includes the idea that capital funds are different from operational cashfl ows ; gives a unique solution for every project; ranks projects of unequal size in the same order as NPV; ranks projects having time disparity in the same order as NPV; and ranks projects having unequal lives in the same order as NPV.Finally, the paper defines a yield-based method that meets seven of these criteria. Formal proofs demonstrating the consistency with each criterion are given where necessary. The paper demonstrates the logical inconsistency and conceptual impossibility of any yield-based method discriminating among projects of different sizes.

Capital Budgeting Practices: A Survey in the Firms in Cyprus

“…For example, the study of Pan, Nichols, and Joy (1977) presented some evidence regarding the current state of the art of business sales forecasting practices. McDaniel, McCarty, and Jessell (1988), developed an alternative yield-based capital budgeting technique, the marginal return on invested capital (MRIC). This technique, the authors proved, can be applied more generally than other yield-based methods used as substitutes for the NPV technique.…”

Purchasing power return, a new paradigm of capital investment appraisal

“…Specifically, does the IRR approach implicitly assume the intermediate cash flows generated by a capital investment project are reinvested at a rate equal to the IRR? Even though the verdict is leaning toward no reinvestment rate assumption in the IRR method (Alchian, 1955; Doenges, 1972; Dudley, 1972; Keane, 1979; Meyer, 1979; Bierman and Smidt, 1980; Dorfman, 1981; Nicol, 1981; Beidleman, 1984; Lohmann, 1988; McDaniel et al , 1988; Crean, 1989, 2005; Hartley, 1990; Plath and Kennedy, 1994; Johnston et al , 2002; Karathanassis, 2004; Eagle et al , 2008; Rich and Rose, 2014), a multitude of textbook authors and researchers are still for the reinvestment rate assumption being embedded in the IRR calculation (Chang and Swales, 1999; Block and Hirt, 2008; Keown et al , 2008; Gallagher, 2010; Graham et al , 2010; Gitman and Zutter, 2012; Moyer et al , 2012; Brigham and Houston, 2013; Balyeat and Cagle, 2015). Dudley (1972, p. 908) argues that the origin of the controversy can be traced back to Renshaw’s (1957, p. 193) “inaccurate parenthetical summary” of Solomon’s (1956, p. 127) remark on the ranking of mutually exclusive projects.…”

Evaluating the Investment in the Malaysian Construction Sector in the Long-run Using the Modified Internal Rate of Return: A Markov Chain Approach

“…The MIRR assumes that the returns obtained from the positive cash flows of an investment project will be reinvested at the external rate of return, which is formally equal to the equity's cost of capital. Some financial analysts assert on implementing the MIRR method for both conventional and non-conventional investment projects (Bernhard, 1979;McDaniel et al, 1988;Kelleher & MacCormack, 2004;Kierulff, 2008;Balyeat et al, 2013;Ivanović et al, 2015;Kengatharan, 2016), although the MIRR formula is, in fact, simply an additional exhibition of the NPV (Kulakova & Kulakov, 2014). On the other hand, Kulakov and Kastro (2017) concluded that the IRR method was appropriate in evaluating investment with conventional rather than nonconventional projects.…”