Question

The underlying cause of conflicts in ranking for projects by internal rate of return and net present value methods is:

A) That neither method explicitly considers the time value of money.
B) The reinvestment rate assumption regarding intermediate cash flows.
C) The assumption made by the NPV method that intermediate cash flows are reinvested at the internal rate of return.
D) The assumption made by the IRR method that intermediate cash flows are reinvested at the cost of capital.

Answer 1

The conflict arises due to different reinvestment rate assumptions for intermediate cash flows in IRR and NPV, leading to possible ranking inconsistencies for projects.

Step-by-step explanation:

The underlying cause of conflicts in ranking for projects by internal rate of return (IRR) and net present value (NPV) methods is B) The reinvestment rate assumption regarding intermediate cash flows. Both IRR and NPV are capital budgeting techniques that account for the time value of money. However, they differ in their assumptions about the reinvestment rate for intermediate cash flows. IRR assumes that the cash flows are reinvested at the internal rate of return itself, while NPV assumes cash flows are reinvested at the firm's cost of capital. This discrepancy leads to potential conflicts when comparing projects with uneven cash flow patterns or different durations.