Question

(TCO E) Describe the reinvestment rate problem associated with comparing projects using the internal rate of return.

Answer 1

The IRR is the most used method by managers to compare projects as it gives a single number to compare projects. But the IRR approach is inherently flawed in the assumption that it assumes that the intermediate cash flows generated during the course of the project are reinvested at a rate equal to the IRR.

So, if the actual reinvestment rates are lower than the IRR, then the IRR method would significantly overestimate the annual return from the project. Thus managers using this approach should remember this drawback of the IRR method and make necessary changes to the method. Using a MIRR approach which requires a reinvestment rate as input is a good approach.