Chapter 9, Problem 15CRCT

Internal Rate of Return [LO5] It is sometimes stated that “the internal rate of return approach assumes reinvestment of the intermediate cash flows at the internal rate of return.” Is this claim correct? To answer, suppose you calculate the IRR of a project in the usual way. Next, suppose you do the following:

a. Calculate the future value (as of the end of the project) of all the cash flows other than the initial outlay assuming they are reinvested at the IRR, producing a single future value figure for the project.

b. Calculate the IRR of the project using the single future value calculated in the previous step and the initial outlay. It is easy to verify that you will get the same IRR as in your original calculation only if you use the IRR as the reinvestment rate in the previous step.