A financial metric used to evaluate the profitability of potential investments is a calculation that refines the internal rate of return (IRR) by addressing some of its shortcomings. It assumes that positive cash flows are reinvested at the firm’s cost of capital, while the initial investment is financed at the firm’s financing cost. For example, if a project requires an initial investment of $100,000 and generates positive cash flows over five years, this calculation considers the rate at which those cash flows can be realistically reinvested to determine a more accurate rate of return.
This method offers a more realistic view of an investment’s potential return compared to the standard IRR. It avoids the often unrealistic assumption that cash flows are reinvested at the IRR itself. This is especially important when comparing projects with significantly different cash flow patterns or when the IRR is exceptionally high, making reinvestment at that rate unlikely. Its historical context lies in addressing the limitations of the traditional IRR, providing a more reliable decision-making tool for capital budgeting.
