-Yolume 33 - Number 4 The Engineering Economist Summer 1988 } Net Present Value and Rate of Return: Implicit and Explicit Reinvestment Assumptions Robert ¢. Beaves ‘The University of Iowa ARSTRACT ‘This paper introduces generalized aor presen: value end race of return tndlees whch allow che analyst to specify o relnvestneat race. Conventional net present value and incernal race of return fndices 40 not acconodace an independent reinvestaent rate apd thus do net alloy the analyst © assure a common reinvestaent rate vhen comparing investiene altermacives, The frdices incrodaced Net present value and internal rete of return are the most widely used and accepted discounted cash flow (DCF) indices for investment project evaluation. It is well established that these to indices my produce different rankings of competing investment projects [1, 13, If]. Renshaw [16] and Solomon [17] attribute these differences to different implicit assumptions regarding the reinvestnent of project cash flows. Others, however, claim that these indices make no reinvestment assumptions, implicit or otherwise [3, 5, 6, 8, 10]. Tals paper introduces two DCF indices which permit an independent specification of the return earned on reinvested project funds. In one sense these indices are not new: rather they are generalized net present value and rate of return formulations. These general formulations (NPV* and RORX) are * consistent with conventional formilas for net present value and internal rate of return (NPV and IRR) when NPY and IRR are seen as special cases incorporating the assumptions noted by Renshaw and Solomon. Numerical examples are used to denonstrate 1) the flexibility provided by tho NPY# and RORK indices as compared to NPY and IRR and 2) their superiority as compared to other DCF indices which permit an explicit reinvestment rate assumption. 275376 ‘The Engineering Economist I. The Use of a Reinvestment Rate in Project Evaluation ‘The following statements by Solomon [17] are favorably cited by authors on 16]: both sides of the implicit reinvestment assumption issue [t ‘The valid comparison is not simply between co projects but between two alternative courses of action. ... In order to make a fair comparison. an explicit and common assumption mist be nade regarding the rave at whtch funds funds released by either project can be reinvested up to the terminal date Solonon is addressing the need to put competing projects on equal footing if one is to make a fair comparison. [t is well established that a valid project comparison requires @ conmon investment horizon, ty thru t,, ‘The reinvestment issue arises with respect to funds which. although attributable to a project, are not needed by that project for sone period of time within the investment horizon. For comparison purposes. it is generally assuned that such funds can be reinvested elsewhere until needed by the project or unttl t,, Solomon! suggests that a fair project comparison requires 1) that returns which could be generated during the investment horizon by reinvesting a project's funds be credited to that project, and 2) that the reinvested funds of al? Projects be assumed to earn the same rate of return’, i.e., a common reinvestment rate. Note that this assumption is for comparison purposes only and does not mandate that future cash flows actually be reinvested rather than consumed. Dudley [6], whe claims that there are no reinvestment assumptions implicit im the NPY or IRR indices. offers the following thoughts: The assumptions about reinvestment rates are implicit, unknowingly and by default, in the decision to use one or the other of the two criteria and not to make any explicit estimate of the possible return on reinvest- ment of intermediate cash flows received prior to the terminal date. The importance of this distinction lies in the fact that the erroneous belief implies thac the problem 1s beyond the practical control of the analyst. ... In fact, ... the difficulty is easily handled by the analyst, if only he will recognize its existence and its cause. This author disagrees with Dudley’s contention that a common reinvestment rate can be easily specified by an analyst using the NPY or IRR indices. In fact, it is the failure of HPV and IRR to accomodate a common reinvestment rate -- and therefore fair project comparisons —- that provides the impetus for this paper.Volume 33 - Number 4 27 Grant [8] argues against the use of reinvestment rates in project evaluation because such use can distort the attractiveness of a project. As he correctly points out, any project can be made to appear attractive by assuming a high reinvestment rate or to appear unattractive by assuming a low reinvestment rate. The fact that assuming an unrealistically high or low reinvestment rate can distort the attractiveness of & project “does not, however, argue against the use of reinvestment rates in project evaluation. Rather, it argues against the use of unrealistic reinvestment rates; ti.e., rates not tied to market expectations. After all, the NPY of any project can be distorted by using an unrealistic discount Fac8, yet this is hardly a valid argument against the use of discount rates in project evaluation. Again, Crant [8] correctly observes that @ rate of return calculated using.a reinvestment rate is actually the result of tvo separable investments, one which earns the project's IRR and another which earns the reinvestment rave. Solomon [27] noted that che valid comparison is not simply between two projects but between two courses of action. Each course of action includes not just Investment in the respective project itself, but also the opportunity to reinvest any funds unneeded by that project. ' Grant recommends the use of the IRR index because it is solely a function of the amounts and timing of a project's cash flows, and chus is the result of a pure, unseparable investment in that project. Surely. however. the IRR does not assume that a project's intermediate cash flows cannot be reinvested or that the Feinvestment rate 1s zero. As is shom herein. the comparison of projects on the basis"Of ‘their IRR’s implios an asoumption that intermediate cash flows from each project's IRR is also the result of tvo separable investments. both of which earn a rate equal to the project's IRR. ‘There is nothing magically correct in assuming reinvestment at the project’s IRR. On the contrary, such an assumption precludes a fair comparison of projects that have different IRR's. Further, the project's IRR often is not a realistic reinvestment rate and can distort the project's attractiveness. An investment project is characterized by a finite sequence of net cash represents the incremental cash flow that is flows, a; ({=0,1,2.....n), wheresa The Engineering Economist expected at time ¢,. A negative a, represents the project's nesd for additional funds at time t,. whereas a positive a, represents finde released at time t, as then unneeded by the project. For each project, tg represents the point in time at which the first cash flow related to that project occurs and that cash flow is assumed to be negative: i.e., aq 0. Likewise, a project terminates at ¢, which represents the point in time at which the last cash flow related to that project is expected to occur. The conventional formila for net present value is: « cs Nerpenalaay (sh) rs) cot where k= the minimum rate of return which the project must provide to be accepted; i.e., the minimum acceptable rate of return. The IRR of an investment project is generally defined as that discount rate for which the project's NPY is zero, With reference to the NPV formala presented in Equation (1a), the IRR is that discount rate q such that? ng : O = NPY, =) a, (t40)$ (2) i=0% Ascuning a reinvestment rate of r, the ‘PROJECT-BALANGE at time t, is defined ey Tetetiedew eee) [Hey we fenton s Je A sry =) a, ery 2) iso where: the assumed reinvestment rate.“Volume 33 - Number 4 279 For a given reinvestment rate, a project which has no negative project balances is referred to as a PURE FINANCING PROJECT. Given reinvestment rate r, a project's FUNDED BALANCE at cime £; depends on the sequence of capital inputs made to that project and {s defined as follows: = ryt Flr) = ) Gad) (3) t=0 where a I, = the investor's capital input art). 1, 20, A sequence of capital inputs for which all funded balances of a project are nonnegative is said to FULLY FUND that project. For @ given reinvestment rate a project's INVESTMENT BASE is the minimum initial capital input, I), which will fully fund that project assuming all other capital inputs ere zero. For a given reinvestment rate and assuming that Ty vs the only nonzero capital Input and is equal to the project's investment base, a Project's RESULTANT VALUE is equal to F,(r]2 the project's funded balance at ¢, and the project's TRANSITION POINT is the earliest point in time at which the project’s funded balance is equal to zero. TIT. GENERAL*NET PRESENT” VALUE AND RATE OP RETURN CONCEPTS The attractiveness of a proposed investment project depends on the effect that project is expected to have on the wealth of the investor; more specifically, the effect it is expected to have on that portion of the investor's wealth which is committed by undertaking the project. Eeonomié evaluation of ah investment project consists of a comparison of the amount of wealth committed to the project-at ception with the wealth‘anount attributable to the project « atuits termination. Note that the base for this comparison is the wealth committment required of the investor to fully fund the project, a “stock” concept, and not merely ao, the initial cash flow.280 The Engineering Economist 4m investor's initial and terminal vealth positions with respect to a project are often compared using net present value or rate of return indices. Net present value and rate of return can be defined in a general sense as: Sy! + net present value i (4a) (8)? Wain rate of teturn’ feh =19 (4) 0 where Wo = INITIAL WEALTH COMMITMENT; i.e., that amount of wealth which is committed at ty by undertaking the project. = TERMINAL WEALTH; i.e., that amount wealth that is expected to be attributable to the project at t. So defined, net present value represents the discounted value at ty of the incremental wealth attributable to the project, and rate of return represents the average rate earned per period on wealth committed to the project. IV. THE IMPLICIT REINVESTMENT ASSUMPTTON, Net present value and rate of return are essentially single-period indices designed for projects that have no intermediate cash flows. These indices are uniquely determined only vhen the investor's initial vealth commitment ¥ and hie terminal wealth. W,. are uniquely determined. Without a reinvestment assumptii Wp and W, are uniquely determined only for projects chat have no internediate sash flows. These single-period indices can be generalized to projects that have intermediate cash flows, but such generalization requires a reinvestment assumption whether implicit or explicit. Hirshletfer [9] suggests that the short-comings of the IRR index are attributable to its generalization fom single-period ‘to’ multi-period analyses; 1.e., to projects with intermediate cash flows.Yolume 33 - Number + 281 Projects A. B and C in Table 1 each require an initial wealth commitment, Yor of $100,000 and have a minimum acceptable rate of return of 10%. Although Projects A and B have the sane NPY, to conclude that they are equally attractive Fequires an assumption that Project A's expected cash flow of $61,512 at t, can be invested until ty at 10%, the discount rate. Likewise. to conclude that Projects A and C are equally attractive based on their identical 15% IRR’s Fequires an assumption that the sane $61,512 cash flow can be invested until ¢, at 18%, Project A's IRR. Project A's terminal wealth. ¥,: is not uniquely determined without a reinvestment assumption. If the reinvestment rate is assumed to be 10%, Project A's ¥_ is $129,175; hovever, if the reinvestment rate is 15%, Project A's ¥,, is $132,250 Table 1 Implicit Reinvestment Assumption Projects A, B and C Time Project A Project B Project C ty -100.000 100,000 100,000 & 61,512 0 ° ty 61,512 129, 175. 132,250 NPV q $6,755 $ 6,756 $ 9,298 IRR 15.00% 13.66% 15.00% Projects D, E and F Time Project D Project £ Project F ty ~ 40,445 ~ 77,213 ~ 75,614 tp ~ 40,445 ° 0 ty 100,000 100,000 100,000 WV) $8,431 $5,431 $7,131 IRR 15.00% 13.90% 15.00%282 Projects D, E and F in Table 1 cach offer a terminal wealth, ¥,, of $100,000 end have a minimum acceptable recurn of 10%. Project D is fully funded with an initial wealth commitment, ¥,, of $75,614 if the funded balance of $25,169 at ¢ ($75,614 ~ $40,445) can be reinvested at 15% until t when its compounded value 0 would be $40,445. Likewise, Project D is fully funded with a Wo of S77.213 if the funded balance of $36,768 at ty (877.213 ~ $40,445) can be reinvested at 10% until t), when its compounded value would be $40,455. If the reinvestment rate equals Project D's IRR of 15%, Projects D and F are equally attractive. However if that rate equals the 10% minimum acceptable return, Projects D and E are equally attractive. V. TRANSITION POINT, INVESTMENT BASE AND RESULTANT VALUE ‘The concept of a project transition point is critical ro determining a project's investment base and resultant value. The project transition point divides a projects cash flows into two mutually exclusive and all-inclusive cash flow streams, an investment stream and a return stream. The cash flows which occur prior to or at the transition point form the INVESTMENT STREAM. All cash flows occurring subsequent to the transition point form the RETURN STREAM. A project's investment base is equal to -1,0 times the present value of its investment stream as discounted to ty. Its resultant value is equal to the future value of its return stream as compounded co t,. In each case the respective discount or compounding rate is the assumed reinvestment rate, Civen reinvestment rate r, « project's investment base and resultant value can be expressed algebraically as 1 surpanwpae vase =i J ageeted iso (6a) resultant value = (5b)Volume 33 - Number 4 283 where: t, is the project’s transition point as defined belov. For a given reinvestment rate, the project TRANSITION POINT is the earliest time ¢, whereafter the project's remaining stream of cash flows + Tequires no capital (pep eByqe++d,) is economically self-sufficient; { inputs. In other words, the project transition point is the earliest time point for which the project's subsequent cash flows comprise a pure financing project for the given reinvestment rat Determining a project's transition point ts not as difficult as this definition nay suggest. For a given reinvestment rate, ty is the project transition point if the following conditions are satisfied: 1) The net cash flow which occurs at ¢, 1s negative: i.e., a, <0. 2) The first net cash flow which occurs subsequent tot, {= nonnegative: fe ay, 20. 3) Among those time points which satisfy the above two conditions, the project balance is lowest at ty Note that a project's transition point can vary for different reinvestment rates, although it rarely does. Consider Projects G and H in Table 2 for hich 10% is the assumed reinvestment rate. Project G is a CONVENTIONAL PROJECT, since its sequence of cash flows has only a single sign change: i.e., its first two cash flows are negative and the renaining cash flows positive. Project G's transition point occurs at t,, Its investment stream is comprised of the negative cash flows at 1 to and t,, and its recurn stream 1s comprised of the positive cash flows occurring subsequent to t,. The investment base of any conventional project is equal to the present value of its negative cash flows as discounted to ty at the reinvestment rate ($101,818 for Project G). The resultant value of any conventional project is equal to the future value at t, of its positive cash flows as compounded at the reinvestment rate ($184,600 for Project ¢). Project H is a NONOONVENTIONAL PROJECT since its cash flow stream has more than one sign change. Times ty and ty are both candidates for the transition point of Project H since a negative cash flow occurs at each and is followed by a234 nonnegative cash flow. than at tg; thus ¢ As shown in Table 2, tho project balance is lower at t, The Engineering Economist 2 gq $8 the transition point of Project H given a 10% reinvestment rate. Although Project i's lowest project balance occurs at ty, tq does not meet other transition point requirenents. Once ty is identif: ied as the transition Point, Project H's investment bese of $101,818 (-1.0 times the present value of the investment stream) and its resultant value of $184,600 are caleulated as illustrated in Table 2. Table 2 Investment Base and Resultant Values Cash Flaw 100,000 20,000 -24,200 10,000 75,000 50,000 (r = 10%) Project ¢ Project! Present Yalue Balance Invest. Stream 50,000 50, 000 112,000 51,818 63,424 -51.990 -17,413 20,621 “1014618 Project H Proje’ Présént’ Vafe Balancd Invest. Strean -100, 000 ~100,000 99,000 18,182 123,000 20,000 -125,520 83,072 20,621 Future Value Return Stream 52,942, 48,129 43,753 Future Vale | Return Strean 12,100 82.500 90,000 184,690“Yolume 33 - Number 4 285 WI. THE SIGNIFICANCE OF THE INVESTMENT BASE AND RESULTANT VALUE Those ICF indices which accomodate an explicit reinvestment rate differ with Pespect co their definitions of initial committed vealth, Wj. and terminal wealth, ¥,- It is the premise of this poper that a project's investment hase correctly represents the amount of wealth committed when that project is vadertaken, Wo, and that a project's resultant value correctly represents the wealth that Will be attributable to that project at its termination, W. Once a reinvestnent rate is specified, any project can be completely identified for analytical purposes by two numbers, its investment base and sts resultant valuq. Determining a project’s investnent base and resultant value idencifies, for that assuned reinvestment rate, en equivalent project having no intermediate eash flows. That equivalent, two-cash-flow project has the ‘sane time horizon as the original project and consists of @ negative cash flow at ty equal to -1.0 times the original project's investment base and a positive cash flow at t,, equal to the original project's resultant value. Civen a 10% reinvestment rate, Projects G and H in Table 2 are beth equivalent for analytical Purposes to a project thet bas cash flows of ~$101.818 at time ty and $184,600 a: ts, Given a different reinvestment rate, Projects ¢ and H would not be ist equivalent to that same two-cash-flow project, nor to one another. The funded balances of @ project are a function of the capital inputs made to that project. In Table 3 and in Figure 1 the funded balances of Projects ¢ and Hare presented assuming an initial capital input Ty equal to $101,918, their comnon investment base, and all other I, equal zero. The°funded balances of any Project have the following characteristics vhen its initial capital input Ty equals its investment base and all other I, are zero:, 1) All funded balances are nonnegative. 2) The funded balance at the transition point is zefo 3) The funded balance at , is the project's resultant value;‘The Engineering Economist Table 3 Projects Gand H: Funded Project Ralence ‘ime Gash Flow ~50.000 ~57,000 33,776 by 39,776 &, 39,776 e 20,776 Time ash Flsy to 100,000 (r=10%) Project ¢ Capital Tnpurs 101,819 Oe 2000 131,659 184.0007 Fundad Balance 1,818Yolume 33 ~ Number 4 287 184,600 Project 6 X 184,800 Project H , 20,621 100,000 «=~ ~ X tunded bolance «project balance Figure | Project ond Funded Balancesee 288 ‘The Engineering Econonist ‘The investment base and the resultant value Tepresent a hypothetical capital input at tp and a hypothetical project sccounting at ¢,. The assumption of a single capital input at ¢y and a single Project accounting act are for Shelytical purposes only, 4.e. for making a fair comartson 0f competing Prevects, ‘These assumptions in no way mandate or infer how on accepted fnvestment project should actually be funded, VIL. THE GENERAL NET PRESENT VALUE AND RATE OF RETURN FORMULATIONS: Formilas for NPY and RORM are derived by Substituting the investment base and resultant value, Equations (5a) and (Sb), for ¥y and ¥, in the general Sefinitions for net present value and rate of return, Equations (4a) and (4b). The following equations result: a a (try tg take “i TM SE — ) aptaery (62) (ny & ni] tcn 2 9, (sry RoR = feet (Sb) ) -a,terytYolume 33 - Number + 289. J attra] ier = q =|S84E —__}- (7) y aay iso Comparing Equations (Ga) end (7a) or Equations (6b) and (7b) reveals that NPV ond IRR are simply special cases of NPV# and RORX whereln the reinvestment rate is equal to the respective discount rate; i.e., the required tate k for NPY and the TRR for IRR. Thus for any project, NPV , will equal NPY, and RORy will equal IRR. It is noc critical that t, in Equation (7a) actually be the project's transition point. Equation (7a) will yield the same IPY for any t, = t,. Assuming that the reinvestment rate equals the discount rate, Equation (4a) will yield a project's NPY when 1) its cash flows are divided into any two all~ inclusive, but mtually-exclusive subsets and 2) Wy is defined as -1.0 times the sum of the present values of the cash flows in either of the subsets while W, is defined as the sum of the future values of the cash flows in the other subset. ‘An implicit assumption that the reinvestment and discount rates are equal allows NPY to be calculated without reference to a transition poing, initial committed wealth,!"or terial Wealth. Sueh/ésiiepts are necessary, however, if the analyst is -to"assune a Teinvestment rate independent of the respective discount: rater VIII. ALTERNATIVE DCF INDICES ? © me modified internal rate of return (HIRR) and terminal value (TV) are DOF indices which allow the analyst to specify a reinvestment rate. Each of these indices suggests a two-cash-flow project as the cquivalent of the project being analyzed, yet each differs from the other and from NPY* and ROR in terms of how it defines Wp abd W,, che evo cash flows of that equivalent project Nonetheless, if the reinvestment rate equals the required rate k. the Wo, ¥, pair provided by cach of these indices will yield the same net present value using Equation (4a). Likewise, if the reinvestment rate equals the project's IRR, theThe Engineering Economist Yo. W, Pair suggested by each of these indices will Provide the same rate of Teturn sing Equation (4b). There 1a ao such agreement enamt these indices, however, when the reinvestment rate ia specified independent of the discount Tate. ‘Terminal value is a DCF index suggested for use where the analyst desires to make an explicit reinvestuent assumption [2, 3, 6, 17, 18]. The terminal value of an investment project is defined as follow: (10) The terminal value is equal to the future value of all cach flows that occur after tg.+in contrast to the resultant value vhich is equal to the future value ef all cash flows which occur after fq: the project's transition poiné. 4 Project's terminal value and resultant value are equal if that Project's transition point is ty. Terminal value suffers two notable shortcomings as a project evaluation index. First, the terminal values of two projects are comparable only if those Projects have the same initial cash flow, 93. Although two projects have the sane NPY. they will have different cerminal values if their initial cash flows are not equal. AS impossible:toevalunte @’project solely on’ the W,- qNet present value and race of Feturn indices provide such a comparison. ‘Terninal value, as simply one Possible definition of ¥,, does not. Proponents of the termina] value index apparently would define Wo as -1.0 tines the project's initial cash flow: ie, ndex offered by Lin [12] as an alternative to the IRR. The MIRR allows the analyst to specify a reinvestment rate and, unlike the IRR, provides a unique rate for any project. A project's NIRR is deternined as follows:a SRR § §$§ Volime 33 - Number 4 291 (9) where: MIRR_ = the modified internal rate of rerurn assuming a reinvestment rate of r. a, fa, <0, and c, 20, and y, = 0 tf a, 20. In effect, MIRR defines Yq as -1.0 times the sun of the present values of the project's negative cash flows as discounted to ty using the reinvestment rate. Likewise, MIRR defines Was the sum of the future values of the project's positive cash flows as compounded to ¢,, using the reinvestment rate. Thg investment base of a conventional project is equal to -1.0 times the sum of ythe present values of its negative cash flows, while its resultant value {s equal ro the-sum of the future values of its positive cash’flovs., Thus the MIRR, and ROR of a Conventional project are equal ‘The: NIRR of a nonconventional project, however, does not generally equal ifs RORK. Thig"@ifference occurs because NIRK fails to account for the possibility of funding negative intermediate cash flows, in vhole or in part] from prior occur#ing positive flowey Asa result. the’ investment base of @ nonconventions! project is generally less then the Wy (dencnitator) ‘suggested by MIRK and its resultant value is generally less than the ¥, (numerator) suggested by MIRR. [12] {s aware of this shortcoming and offers a second, nore elaborate definition of the NIRR. This author is not convinced that Lin‘s second formilation overcones the shortcomings cited above. Lin's first MIRK formulation is used here.292 The Engineering Economist Rate of return indices such as ROR*, IRR and MIRR are size~independent or Felative measures of econon{c performance in contrast to PV#, NPV and TV which are size~dependent or absolute measures. For example, if a project's size vere Goubled (1.e., each of its cash flows were doubled) the project"s IRR would be umehanged yet its NPV would double. Thus when comparing projects that are not sauel in size, ranking differenées between not present value and rate of return indices my be attributable to the fact that the former are: size-dependent yhile the latter are not. When making stch ‘comparisons, rate of return indices can-be applied to incremental projects (i.e., incremental ahalysis) to obtain rankings consistent with those provided by net present value7 IX. COMPARING DCF TNDIces Consider Projects C, H, Iand J in Table 4. For each of these projects, 10% ie both the minimum acceptable return and the assumed reinvestment rate. The Fesnective Wy. W,, pairs associated with che terminal value index, the NPV and ROR indices, and the MIRR index are provided for all four projects in Table 4, Fquations (4a) and (4b) are used to calculate a net present value and a rate of return for each Wy, W,, pair. Net present values hased on the terminal value and modified internal rate of return indices are labeled RPV py and IP¥yrpn Tespec— ‘ively. Likewise, the rate of return based on a terminal value indice is labeled RORpy: An index equivalent to ROX-y and referred to as "Solonon’s average rate of return” 4s evaluated by Bernhard [4]. Weston and Brigham [19] use an index eauivalent to NPY;y to incorporate a reinvestment rate vhen using the net present value index. 4s noted earlier, the ¥) and ¥, values assigned by the NIRR index toa Senventional project are equal to the project's investment base and resultant value. Because Project G is a conventional project, its NPY* and TV rep equal as are its ROR and MIRR. Again as noted earlier, the Wp. ¥, values aneVolume 33 - Number + Table 4 Comparison of DCF Criteria (e108) Tine Project G Project # Project I ty ~50,000 100,000 100,000 ty 57,000 20,000 25,000 ey 39,778 24,200 20,000 ty 39,776 10,000 50,000 ti, 39,776 75,000 50,000 ts 39.776 30,000 56,189 WV .5 $12,804 $12,804 $12,804 TRRe 14.67% 13.18% 13.71% ‘TERMINAL VALUB $50,000 $100, 000 $100,000 $101,147 $181,072 $181,672 $12,804 $12,804 $12,804 15.13% 12.69% 12.88% $101,518 $101,818 $100,000 $184,600 $184,600 $181,672 $12,804 $12,804 $12.04 12.64% 12.54% 12.68% WODIFIED INTERNAL “RATE OF RETURN) $101,818 $120,000 $116,529 $184,500 $213,882 $208,292 $12,804 $12,804 $12,804 12.64% 12.25% 12.32% 203 Project 80,000 60,000 25,000 -30,000 100,000 21,241 $12,804 16.49% $80,000 $149,462 $12,804 13.32% 380,000 $149, 462 $12,904 13.32% $147,618 $258,362 912,504 11.95%204 The Engineering Econoni st implied by the terminal value index equal the investnent base and resultant value if the project transition Point te to. Thesassreren Point of both Projectg 1 sed-S-18 go. Thus the NVny's of Projects T ang J equal their respective NP Ye 5 Sndtheir ROR 's equal their Tespective ROR 57 The NPYx, NPY ny and ‘NPVvreR Of @ project are equal ff 1)Fae Yolume 33 - Nunber 4 208 The MIRR for Project J in Table 4 is the lowest rate of return reported across the four projects. Nonetheless, Project J has the highest IRR of those Projects and the other rate of return indices all rank it higher than Projects or I. The modified rate of return suggests a ¥, of $147,618 for Project J. nearly double the vealth commitment required for that project by the other indices. A glance at the cash flow stream expected of Project J confirms that even with a reinvestment rate of 0%, a sum as low as $85,000 will fully fund Project J to its termination. This highlights the primary weakness of the NIRR index; i.e., the fatlure to account for the possibility of funding negative intermediate cash flows from prior-oceuring positive flows. ‘X. THE UTILITY OF THE NPV« AND RORx INDICES Assuming perfect markets and certainty, there is no need to specify a reinvestment rare independent of the discount rate of DCF capital budgeting indices. A single interest rate or opportunity cost applies to the project being evaluated and to any reinvestable funds attributable to that project. Given imperfect markets and uncertainty, however, the opportunity cost(s) of Teinvestable funds need not equal the opportunity cost of the project itself due to such factors as 1) transactions costs, 2) the indivisibility of investment opportunities and 3) time horizon differences. The ability to specify a reinvestment rate independent of the investor's minimum acceptable rate of return or the project's IRR can useful in many decision situations. Ome. SENSITIVITY ANALYSIS WITH RESPECT TO THE REINVESTMENT RATE With the NPY index, the reinvestment rate can be varied only by varying the discount rate. Thus the NPY index does not allow the analyst to isolate the effect that varying the reinvestment rate my have on a project's net present | value. The NPY* rate allows the analyst to vary the reinvestment rate while holding the discount rate constant and vice versa Consider the NPY* rankings of Projects G. H. I, and J presented in Table 5 with the discount rate is fixed at 10%, The rankings provided by NPY are H, I, J, G if the reinvestment rate is 6% or 8%: G-H=I=J at 10% and G. J, I, H if 19% is the reinvestment rate. The analysis presented in Table 5 demonstrates not Just the sensitivity of the APY project rankings to changes in the reinvestment296 The Engineering Economies Tate, it also denonstrates the varying sensitivity of individual Projects to such changes. The NPY of Project G varies from $4,267 to $17,148 as the reinvestnent Tate ig varied from 6X to 12%. ceteris paribus. For those same’ reinvestuent rates, the NPY of Project E only varies from $9,553 to $14,304. The IRR provides no method for varying the reinvestment rate, whether in Senibnction with the discount rate or othervise. The rate of return generated by * Project is, nonetheless, dependent upon the rate its reinvested funds can be capected to earn. The RORM index allows che analyst to observe the effect that changes in the reinvestnent rate have on the rankings of projects by rates of Fetira and on the rates of return of individual projects. For example, ROR ranles the projects in Table Sas H, I, J, Cif the reinvestment rate is 6%: J. Hw 1. G 1f the reinvestment rato is 8%; J, I, Gf if the reinvestment rate is 10% and J. G. I, Hif 19% is the assumed reinvestment rate. As observed earlier in Table 4, the ROR and NPY indices do not necessarily Yield the same project rankings for a given reinvestmont rate. Again, such renking differences between ROR and NPYX are due to size differences ‘among the independent Ressures of performance whereas net present value indices are size-dependent. Projects and to the fact that rate of return indices are siz. For a given reinvestment rate, RORY and NPY* will always yield identical rankings if the projects being ranked are the some size; i.e., if their investment bases are equal for that reinvestment rate. B. RANKINGS BASED ON RATE OF. RETURN INDICES Aithough ‘academicians have long espoused the superiority of the NPV. index, Tate’ of return’ indices continue to be more popular with corporate decision makers (7, 11, 14, 18]. It is not the purpose of this paper to espouse either type of index as correct for all applications. Instead, the object here is to provide rete of return and net present value indices vhich permit the analyst to make an cuplicit reinvestment rate assumption. The equal billing given to rate of revurn indices is Justified. if for no other reason, by their vide acceptance among, corporate decision makers. One" serious disadvantage of the IRR index is the assumption of as Teinyestment rate equal to the IRR whlch 1s implicit when projects having. intermediate cash flows are compared on the basis of their IRR's? Variations gin IRK's among projects are due in-part to variations in their assuned retuvestment rates.” It ts this variation in assumed reinvestment rates that precludes fairfz lz ie Slume "33. - Number 4 237 Table 5 Sensitivity Analysis for Reinvestment Rate (=10%) Project G Project 1 Project I Project J 50,000 100.000 100,000 80,000 57,000 20,000 25,000 60.000 38,776 24.200 20,000 25,000 39,776 10,000 50,000 90,000 30,776 75.000 50,000 ~ 100,000 38,776 90,000 56,189 27,241 Rankine, 14.67% 13.14% 13.71% 16.49% JG. $4,269 $9,553 $7,488 $5,464 HL 10.89% 11.97% 11.60% 11.46% HIG $8,513 $11,191 $10. 106 $9,032 HLJG 11.76% 12.31% 12.14% 12.38% JAG $12,804 $12,804 $12,804 $12,804 G-HeI=J 12.64% 12.68% 12.68% 13.39% J.1.Get $17,146 $14,304 $15,584 316,769 GLE 13.51% 12.96% 13.23% 14.27% JG.1.8The Engineering Economist mowing that he can earn at most 6% on reinvested cash flows. Based on the IRR i index, Project J with a 16.49% IRR would be preferred to Project H yhich has a 13.14% IRR, However, this IRR rankings assumes that Project H's cash flows can be reinvested at 16.91% while Project E's cam earn only 13.14%. Tha ROR* allows the investor to assume a conmon reinvestment rate of 6%, in yhich case Project H with an RORY of 11.97% is preferred to Project J vhose RORY is 11.46%. Whatever the advantages or disadvantages of rate of return indices, the ROR© index Nspresents @ Significant improvenent for those practitioners who use rate of return indiees. C. RISK-ADJUSTED REQUIRED RATE OF RETURN Conpared to ranking by IRR, project ranking by IPY 1s less problenatic with Fespect to the assumption of a common reinvestment rate. As long as the sane discount race 1s used to determine the NPV's of competing projects. a common Tetnvestment rate equal to thet discount rate is assumed. A preblen’does arise, however, when risk-adjusted discount rates are used to compensate for perceived risk differences anong competing projects Under such circumstances? the assumption of a common reinvestment rate is lost.’ NPY vill nOt provide a fair comparison of competing projects if different discount rates are used dn caleulating the PV's of those projects. ‘ThesiPY4={ndex-does permit =the spectf cation’ of /a*conmon’ reinvestment rate when’ comparing: projects: that have different minimum acceptable rates of return ‘The"comon reinvestment rate my itself be adjusted for risk. In thie case, the adjustment is a risk discount in contrast to the risk premium used to adjust the discount rate. This decrease in the reinvestment rate reflects flects the risk that the expected reinvestment rate my not be realized and increases as this Fisk Increases. Of course this riak adjustment is not project-specific so that the assumption of a common reinvestment rate is maintained. D. 2 WITH MULTIPLE IRR? 5 Not all projects have a unique IRR, Sone have no IRR while others Mive multiple IRR's [9, 13]. Further, vhen applied to Projects which have multipleVolume 33 - Number 4 299 ARR's, NPY may provide troublesome results [18]. Within sone range of potential discount rates, the WPY.of such a project changes sign fron negative to posi tive asthe discount rate is increased, thereby implying that a project which ts unacceptable at one discomt rate is, nonetheless, acceptable at a higher rate. This result appears to be logically inconsistent. A project acceptable at one discount rate should be acceptable for all lower rates. This result is understandable, however, if one recalls that the NPV index does not provide for specification of a reinvestment rate independent of the discount rate. Everything else equal, an increase in the discount rate yields a decrease in net present value: whereas an increase in the reinvestment rate yields an increase in net present value, everything else equal. With the NPY index, an increase in the discount rate also increases the reinvestment rate, but will generally result in a lover net present value. For projects having multiple IER's, however, the effect of increasing the reinvest- ment rate overpowers the effect of increasing the discount for some rates. Thus a net increase in net present value results from an increase in the discount rate. By allowing independent specification of a reinvestment rate, the ROR* and NPY indices eliminate the problens associated with projects that have multiple FRR's! Once a reinvestment rater is specified, 1) every project has a unique FORE, 2) the project's NPV# , is positive for any discount rate k less than RORx, 3) the project's NPVg | is negative for any discount rate k greater than ROR*, Er f and 4) NPY¥ | decreases as the discount rate k increases. E. PROJECTS WITH TIMING DIFFERENCES A rather problematic capital budgeting situation occurs when the investor must choose amorg projects whose initial and/or terminal cash flows occur at different points in time, i.¢., projects with timing differences. Several approaches have been suggested for handling this problem and this paper will not delve into the relative nerits of each. Nonetheless, one nethod of dealing with Project timing differences is to make an explicit reinvestnent rate assumption. The NPV* and ROR indices facilitate such analysis because they can incorporate an explicit reinvestment rate assumption. To use NPY and ROR® to compare projects that have timing differences ityis first necessary to define’a connon tine horizon over which those projects are to be comparéd. The point in time at vhich the first cash flow related to any off300 The Engineering Economist the projects being compared occurs is denoted as to for all of the projects. The pomne-in-time:at which the final cash flow related to any of the projects oceurs ‘e'denoted as ¢,, for all of the projects. Projects whose first cash flows bezin subsequent to ty are assigned a cash flow of zero at tg and other time poincs Prior to that first nonzero cash flew. Likewise, projects whose final cash flow eccurs prior to t,, are assigned a cash flow of zero for times subsequent to their final nonzero cash flow? Once these adjustments have been made, the RORK's and NPV#"s of the projects can be calculated and compared. When comparing projects that have timing differences, it is particularly important to select a realistic reinvestment rate and to do sensitivity analysis with respect to that rate. ia X. CONCLUSION (7 camavetitional net present value and internal vate of return indices do hot Permit the onalyst to specify a reinvestment rate independent of the NPY discount rate or the IRR! Thus in many capital budgeting situations a fair comparison of Competing projects is precluded because a common reinvestment rate cannot be specified. The general net present value and rate of return indices introduced herein allow the analyst to make an explicit reinvestment assumption and, thereby, facilitate fair project comparisons. These new indices are relatively easy to calculate and offer a new understanding of net present value and rate of return concepts. Tae"Sbi11ty"€0 spect ty and, therefore, to vary the reinvestment rate al loys sensitivity analysis with respect to that rate! Such sensitivity analysis is useful vhen evaluating a single project on an accept/reject basis or yhen ranking competing projects. For those analysts who prefer a rate of return Index, ROR Tepresents a significant improvement over the IRR index. ROR is not subject to multiple solutions and facilitates fair comparisons by allowing the specification of a conmon reinvestment rate, Indeed, ROR produces project rankings consistent with ‘those produced by net present value in situations where the IRR cannor. Finally, this paper and the indices introduced herein shed considerable }ighe on the reinvestment assumption issue. The author realizes that any reference to reinvestment assumptions as implicit in the NPY and IRR formulations would be unacceptable to some readers. 4m attempt has been made to stress that these reinvestment assumptions are implicit in the way the NPV and IRR