Re-examining an Old Question: Does the IRR Method Implicitly Assume a Reinvestment Rate?

This study reexamines whether the IRR method implicitly assumes a reinvestment rate. Using a numeric example, we show the IRR as a constant rate of return on the declining balance of the investment, with neither an implied disposition of the intermediate cash flows nor an implicit rate of return on any reinvested cash flows. Analogous examples are presented for a coupon bond purchased at a premium and a fully amortized loan. Rewriting the IRR equation may appear to justify an implicit reinvestment rate, but such a view is shown to be incorrect. These findings suggest that finance textbooks should disavow any implicit reinvestment rate assumption in the IRR technique. Further, textbooks should highlight the IRR as the rate of return on the declining balance of the investment, analogous to the YTM on a premium bond and the contract rate on a fully amortized loan.