reinvestment rate

(noun)

The annual yield at which cash flows from an investment can be reinvested.

Related Terms

Examples of reinvestment rate in the following topics:

  • Reinvestment Assumptions

    • NPV and PI assume reinvestment at the discount rate, while IRR assumes reinvestment at the internal rate of return.
    • Related to this concept is to use the firm's reinvestment rate.
    • Reinvestment rate can be defined as the rate of return for the firm's investments on average.
    • IRR assumes reinvestment of interim cash flows in projects with equal rates of return (the reinvestment can be the same project or a different project).
    • Accordingly, MIRR is used, which has an assumed reinvestment rate, usually equal to the project's cost of capital.

  • Modified IRR

    • Firstly, IRR assumes that interim positive cash flows are reinvested at the same rate of return as that of the project that generated them.
    • This is usually an unrealistic scenario and a more likely situation is that the funds will be reinvested at a rate closer to the firm's cost of capital.
    • The formula adds up the negative cash flows after discounting them to time zero using the external cost of capital, adds up the positive cash flows including the proceeds of reinvestment at the external reinvestment rate to the final period, and then works out what rate of return would cause the magnitude of the discounted negative cash flows at time zero to be equivalent to the future value of the positive cash flows at the final time period.
    • To calculate the MIRR, we will assume a finance rate of 10% and a reinvestment rate of 12%.
    • Second, we calculate the future value of the positive cash flows (reinvested at the reinvestment rate): FV (positive cash flows, reinvestment rate) = 5000*(1+12%) +2000 = 7600.

  • Reinvestment Risk

    • Reinvestment risk is more likely when interest rates are declining.
    • For example, falling interest rates may prevent bond coupon payments from earning the same rate of return as the original bond.
    • Especially with the short-term nature of cash investments, there is always the risk that future proceeds will have to be reinvested at a lower interest rate.
    • Reinvestment risk affects the yield-to-maturity of a bond, which is calculated on the premise that all future coupon payments will be reinvested at the interest rate in effect when the bond was first purchased.
    • Interest rate on the bond - The higher the interest rate, the bigger the coupon payments that have to be reinvested, and, consequently, the reinvestment risk.

  • Calculating the NPV

    • There are many methods for calculating the appropriate discount rate.
    • Since many people believe that it is appropriate to use higher discount rates to adjust for risk or other factors, they may choose to use a variable discount rate.
    • Another approach to selecting the discount rate factor is to decide the rate that the capital needed for the project could return if invested in an alternative venture.
    • Related to this concept is to use the firm's reinvestment rate.
    • Reinvestment rate can be defined as the rate of return for the firm's investments on average, which can also be used as the discount rate.

  • Disadvantages of the IRR Method

    • IRR can't be used for exclusive projects or those of different durations; IRR may overstate the rate of return.
    • In addition, IRR assumes reinvestment of interim cash flows in projects with equal rates of return (the reinvestment can be the same project or a different project).
    • Therefore, IRR overstates the annual equivalent rate of return for a project whose interim cash flows are reinvested at a rate lower than the calculated IRR.
    • When the calculated IRR is higher than the true reinvestment rate for interim cash flows, the measure will overestimate–sometimes very significantly–the annual equivalent return from the project.
    • NPV vs discount rate comparison for two mutually exclusive projects.

  • Comparing Price Risk and Reinvestment Risk

    • Price risk is positively correlated to changes in interest rates, while reinvestment risk is inversely correlated.
    • Price risk and reinvestment risk both represent the uncertainty associated with the effects of changes in market interest rates.
    • Reinvestment risk and interest rates are inversely correlated.
    • In summary, price risk and reinvestment risk are two main financial risks resulting from changes in interest rates.
    • The former is positively correlated to interest rates, while reinvestment risk is inversely correlated to fluctuations in interest rates.

  • Multiple IRRs

    • In this case a discount rate may be used for the borrowing cash flow and the IRR calculated for the investment cash flow.
    • In a series of cash flows like (−10, 21, −11), one initially invests money, so a high rate of return is best, but then receives more than one possesses, so then one owes money, so now a low rate of return is best.
    • When a project has multiple IRRs, it may be more convenient to compute the IRR of the project with the benefits reinvested.
    • Accordingly, Modified Internal Rate of Return (MIRR) is used, which has an assumed reinvestment rate, usually equal to the project's cost of capital.
    • Explain the best way to evaluate a project that has multiple internal rates of return

  • Disadvantages of Bonds

    • Bonds are subject to risks such as the interest rate risk, prepayment risk, credit risk, reinvestment risk, and liquidity risk.
    • Fixed rate bonds are subject to interest rate risk, meaning that their market prices will decrease in value when the generally prevailing interest rates rise.
    • Bonds are also subject to various other risks such as call and prepayment risk, credit risk, reinvestment risk, liquidity risk, event risk, exchange rate risk, volatility risk, inflation risk, sovereign risk, and yield curve risk.
    • Bond prices can become volatile depending on the credit rating of the issuer – for instance if credit rating agencies like Standard and Poor's and Moody's upgrade or downgrade the credit rating of the issuer.
    • This creates reinvestment risk, meaning the investor is forced to find a new place for his money.

  • ROE and Potential Limitations

    • Return on equity measures the rate of return on the ownership interest of a business and is irrelevant if earnings are not reinvested or distributed.
    • Return on equity (ROE) measures the rate of return on the ownership interest or shareholders' equity of the common stock owners.
    • The true benefit of a high return on equity comes from a company's earnings being reinvested into the business or distributed as a dividend.
    • In fact, return on equity is presumably irrelevant if earnings are not reinvested or distributed.

  • Dividend Reinvestments

    • Dividend reinvestment plans (DRIPs) automatically reinvest cash dividends in the stock.
    • This is called a dividend reinvestment program or dividend reinvestment plan (DRIP).
    • The purpose of the DRIP is to allow the shareholder to immediately reinvest his or her dividends in the company.
    • Participating in a DRIP, however, does not mean that the reinvestment of the dividends is free for the shareholder.
    • Thus, participating in a DRIP helps shareholders avoid some or all of the fees they would occur if they reinvested the dividends themselves.