On a purely theoretical basis, IRR is the better approach to capital budgeting than NPV because IRR implicitly assumes that any intermediate cash inflows generated by an investment are reinvested at the firm's cost of capital.

Question

Quizplus · Accepted Answer

IRR actually assumes that intermediate cash inflows are reinvested at the project's own internal rate of return, not the firm's cost of capital, which can lead to unrealistic reinvestment rate assumptions, especially if the IRR is significantly high. NPV uses a discount rate that reflects the firm's cost of capital, providing a more realistic approach to evaluating the value added by a project.

On a Purely Theoretical Basis, IRR Is the Better Approach