**3.1 Reinvestment assumption**

634 Mechanical Engineering

find an interest rate at which inflows exactly equal outflows. The internal rate of return is

0

 <sup>0</sup> 1

*i*

(2)

1 *<sup>n</sup> <sup>i</sup>*

*i CF <sup>I</sup> IRR*

In equation 2, *CFi* stands for the cash flow in period *i*, *n* means the number of periods and

With investment projects in engineering we often encounter a residual value when the lifecycle of the project or investment is ended. Ling and Archer (2008) emphasise that it is necessary to take into account the cash flow from the sale of a property and not only the periodic investment inflows of cash. In such cases, it is important to include in the last projected cash flow any potential (marketable) residual value of a project or an investment. Recent research by Pšunder and Cirman (2011) states that the residual value of an investment usually appears as a positive cash flow, but in some cases it can also be a negative one: for example, if we are dealing with the removal of a completely derelict property or a property with a very low value, then the cash outflows for the removal are

Both the net present value method and the internal rate of return method derive from the same time value of money formula. However, they give a different type of indication. The net present value method gives an absolute size, while the internal rate of return method gives a relative indication. For optimal decision making, both methods should be used in practice. Both are valuable pieces of information in the decision process. In most cases, both the net present value method and the internal rate of return method will give the same

**3. Flaws in use of discounted cash flow models for evaluation of engineering** 

The net present value method principally does not contain any methodological assumptions or deficiencies that could impact the result of evaluation. However, the results are harder to understand in comparison to the percentage from the internal rate of return method. It would not be very meaningful if the investor were to determine that the net present value of a project or an investment were, for example, 25,000 EUR. It certainly may be difficult to compare this result with alternative investments, like real estate investment, bonds or cash deposits. It would be certainly more understandable if the result were expressed as a percentage of internal rate of return. This is probably the main reason that the internal rate

In contrast to the net present value method, the theoretical findings identify numerous limitations connected with the internal rate of return method. The most significant are the

calculated from the following equation:

*IRR* is the internal rate of return.

advice (Brozik, n.d.).

of return method is often more popular.

 internal rates of return are non-additive, possibility of multiple internal rate of return,

possibility of conflicting advice with the net present value method.

reinvestment assumption,

**projects** 

following:

greater than the inflows from the liquidated property.

Reinvestment assumption means that all cash flows from the proposed investment are reinvested at the same rate of return as the internal one. Brozik (n.d.) explains that reinvestment assumption means that, if you are really going to get, e.g., an 8 percent return on the proposed investment, each cash flow must earn 8 percent for the life of the project. The more common way to state this is that, in order to achieve an 8 percent return on the entire investment, all cash flows must be reinvested at 8 percent until maturity. No cash flows can be diverted for other purposes. No better investments can be taken should they come along. The cash is essentially tied up for the life of the project, and you must find projects that will return 8 percent for the various time horizons each cash flow faces.

It is unrealistic to expect that all the cash flows from the proposed project will be reinvested at exactly the same rate of return as the internal one, which means that the internal rate of return will return distorted results. How intense the distortion will be depends mainly on the difference between the internal rate of return of the proposed investment and the reinvestment rate of return.

The problem can be overcome by using modified internal rate of return. However, although the modified internal rate of return method clearly overcomes several problems of the internal rate of return method, according to Pšunder and Ferlan (2007), it is the least popular discounting method among engineers. Half of mechanical engineers use the modified rate of return method for project or investment evaluation, but only 13.3 percent of engineers other than mechanical engineers do so. Moreover, only 37.5 percent of mechanical engineers are aware of the possibility of flaw in results due to reinvestment assumption.
