Revisiting the Reinvestment Rate

Abstract

Corporate Finance textbooks make a suggestive statement about the reinvestment of the cash inflows from a project. Two mutually exclusive project proposals, NPV and IRR can give conflicting decisions. In case of one project, the NPV may be superior while for the other project, the IRR may be superior. This paper explains how such a situation can be resolved by using what is known as 'Fisher's rate'. The assumption regarding the reinvestment rate is fundamental to the discussion about capital budgeting decisions and recognizing the reinvestment rate in an explicit manner is essential for appreciating the implications of the NPV/IRR methodology on investment decisions. This paper explains how investment decisions can be refined using Fisher's rate and introduces the concept of 'Modified NPV' using the Terminal value approach.