Final answer:
Capital budgeting using NPV and IRR techniques assumes reinvestment of cash flows at the project's IRR and certainty of these cash flows. They also assume consistency of the discount rate and access to capital at the IRR. Evaluating the validity of these assumptions is crucial for accurate capital budgeting.
Step-by-step explanation:
The use of Net Present Value (NPV) and Internal Rate of Return (IRR) techniques in capital budgeting involves certain assumptions. These methods assume that all cash flows are reinvested at the IRR for that project, and that the project's cash flows are certain and occur as predicted. Moreover, they presume that the firm has access to capital at the project's IRR, and the discount rate used is correct and remains constant over time. The NPV assumes that cash flows are reinvested at the firm’s cost of capital, while the IRR presumes reinvestment at the IRR itself.
Every firm must assess whether these assumptions are valid given the context of their specific investment project. For example, firms often acquire financial capital to fund their investments through mechanisms such as early-stage investment, profit reinvestment, loans, or issuing stock. Each of these sources of capital comes with its own cost and return expectations. An important consideration in capital budgeting is the present discounted value of future benefits, which must exceed the current costs for an investment to be considered worthwhile.