The Real Reinvestment Rate Assumption as a Hidden Pitfall

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.

Profit Reinvestment: Main Motives Supporting Financial Decisions

“…The research shows the focus on the factors of experience in detail. These factors are important for successful entrepreneurial behaviour in line with the studies of Michalski (2009) or Illés (2016.…”

“…In real life we could assume perfect adaptation to the business environment, but this depends on the economic literacy of the business owner, their experience and the problems of the company. There are so many different techniques for decision-making behaviour, which combine financial statements, business perceptions and business environment factors (Simon, 1979;Walker et al, 2011;Illés, 2016). All models want to answer the question of profit maximization, especially in profit reinvestment in explicit or implicit ways, when the main problem is not actually the reinvestment rate, but the critical reinvestment rate (Meyer, 1979).…”

“…The optimal reinvestment rate is different, financial advisors recommend 64% of reinvestment, when reinvestments in engineering are recommended below 20 % (Walker et al, 2011). To be able to measure return rate, Illés (2016) proposed the following formula:…”

Non‐monotonic NPV Function Leads to Spurious NPVs and Multiple IRR Problems: A New Method that Resolves these Problems

“…When the NPVs are zero at 6.6 per cent and at 36.5 per cent, the positive NPV of $28 at 10 per cent is not consistent with the TVM concepts. The NPV is also not the appropriate criterion for NNCF data to overcome the problem of multiple IRRs (see Campani, ; Illés, ; Merlo, ). Figure is a non‐monotonic NPV function. It is a linear slope coefficient of +9.0617 indicates that with increasing discount rates the NPV is increasing.…”

“…When the NPVs are zero at 6.6 per cent and at 36.5 per cent, the positive NPV of $28 at 10 per cent is not consistent with the TVM concepts. The NPV is also not the appropriate criterion for NNCF data to overcome the problem of multiple IRRs (see Campani, 2014;Ill es, 2016;Merlo, 2016).…”