Chapter 9, Problem 14CRCT

Net Present Value [LO1] It is sometimes stated that “the net present value approach assumes reinvestment of the intermediate cash flows at the required return.” Is this claim correct? To answer, suppose you calculate the NPV 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 required return, producing a single future value figure for the project.

b. Calculate the NPV 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 gel the same NPV as in your original calculation only if you use the required return as the reinvestment rate in the previous step.