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Capital budgeting confusion!!!!

ARSHAD (student-CA_final) (74 Points)

18 September 2011

I was going through the capital budgeting chapter of the institute's study material....But could not understand the REINVESTMENT ASSUMPTION which says:The net present value assumes all cash flows can be reinvested at a discount rate but IRR assumes they are reinvested at the projects IRR.This means projects with heavy cash flows in early years will be favoured by IRR method.

I could'nt understand these lines....I will be highly obliged if someone can elaborate this concept for me as I feel conceptual clarity is of utmost importance..It will be very beneficial if explained with example...thanks in advance...plz reply soon...

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(Guest)

It probably means that ur discount rate & reinvestment rate are equal and ur position is same as it was earlier ie before considering reinvestment.

Say u discount my 10%.Now u consider Reinvestment @ 10%(Discount rate) ull land up @ original position.

Say discount by irr but consider reinversment @ other than different rate ur original position deviates.

Inferences i can draw from this theory,it simply says tat the CF's from Reinvestment wil not affect ur Present value.

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(Guest)

So it assumes only rates of discounting will considered as rates of reinvestment so that ur original present value doesnt deviate.

CA Sahil Singla.. (Service Tax ) (3746 Points)
Replied 18 September 2011

Let me giv u example

Let us assume that a project involving outflow of Rs. 50 at T=0 having Inflow each year of rs. 25 at the end for 3 years each. if u compute NPV at 5% then ans. is Rs. 18.08.

Now, ur lines say that Inflows must be reinvested at Disc Rate of 5%. If we do so then we will get after 3 years the amt. = (25*1.05*1.05) + (25*1.05)+ (25)= 78.8125. Also, we have Invested the rs. 50 which will become 50*1.05*1.05*1.05= 57.8812. The net Cash at T=3 is 20.9312

If u compute the presetn value of this Rs. 20.9312, then it is equal to 18.08. So, it imlies that Reinvestment is automatic & required part of project. If we do not reinvest at 5%, then we wouldn't be getting value ocomputed by NPV method

Same is case with IRR method.

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ARSHAD (student-CA_final) (74 Points)
Replied 18 September 2011

Thank you @ CA finalist and @ sahil sir for your answers...and sahil sir this example really helped me a lot....I have one more question sir.....Why is NPV method preffered over IRR if the case is same with IRR??

I read somewhere projects with heavy cash flows in early years will be favoured by IRR method(HOW COME?)

if this is explained with example then whole concept will be cleared...Thanks again

Gaurav Singh (student) (496 Points)
Replied 19 September 2011

Book says that NPV will be preffered over IRR b'coz NPV gives value in absolute terms (say surplus) but IRR is point of NPV=0.Also,IRR is computed with the help of NPV.This suggest that NPV is superior and should be prffered over IRR..

Though i have confusion over the above discussed topic but it was what i understood..