Which of the following statements is most correct?
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A. B. C. D. E.E
The NPV method implicitly assumes that the rate at which cash flows can be reinvested is the cost of capital, whereas the IRR method assumes that the firm can reinvest at the IRR.
The correct answer is B. The NPV method assumes that cash flows will be reinvested at the cost of capital while the IRR method assumes reinvestment at the risk-free rate.
Let's break down each statement and explain why option B is the most correct.
A. The NPV method assumes that cash flows will be reinvested at the risk-free rate while the IRR method assumes reinvestment at the IRR. This statement is incorrect. The NPV (Net Present Value) method assumes that cash flows generated by an investment project will be reinvested at the cost of capital, which represents the opportunity cost of investing in the project. The IRR (Internal Rate of Return) method assumes that cash flows will be reinvested at the IRR itself, not the risk-free rate.
B. The NPV method assumes that cash flows will be reinvested at the cost of capital while the IRR method assumes reinvestment at the risk-free rate. This statement is the most correct option among the choices provided. The NPV method considers the opportunity cost of capital by assuming that cash flows will be reinvested at the cost of capital, which reflects the return required by investors to compensate for the riskiness of the investment. On the other hand, the IRR method assumes reinvestment at the risk-free rate, which represents the return on an investment with no risk.
C. The NPV method does not consider the inflation premium. This statement is incorrect. The NPV method considers the time value of money, which accounts for the effects of inflation by discounting future cash flows to their present values. By discounting future cash flows, the NPV method implicitly incorporates the inflation premium.
D. The IRR method does not consider all relevant cash flows, and particularly cash flows beyond the payback period. This statement is partially correct. The IRR method considers all cash flows generated by the investment project, including those beyond the payback period. However, the IRR method does not provide explicit information about the timing or magnitude of cash flows beyond the payback period. It only tells you the rate of return at which the present value of cash inflows equals the present value of cash outflows.
E. The NPV method assumes that cash flows will be reinvested at the cost of capital while the IRR method assumes reinvestment at the IRR. This statement is incorrect. As mentioned earlier, the NPV method assumes reinvestment at the cost of capital, not the IRR. The IRR method assumes reinvestment at the IRR itself, not the cost of capital.
In summary, option B is the most correct because it accurately describes the reinvestment assumptions of both the NPV and IRR methods. The NPV method assumes cash flows will be reinvested at the cost of capital, while the IRR method assumes reinvestment at the risk-free rate.