2.7 A Word about Discount and Reinvestment Rates
One reason future reinvestment rates may differ from the internal rate of return is that market interest rates simply need not correspond to some corporate project’s specific internal rate of return. Moreover, market driven interest rates will change with changing market conditions over time.
Even if market interest rates do not change as time goes on, a normal yield curve would indicate lower reinvestment rates over time, i.e., as the project’s horizon gets closer.
Use of the “Spot Rate” curve would enable one to view future short-term reinvestment rates differentially. The Yield-to-Maturity would be the average of the individual rates implied by the Spot Rate Curve.
There are other cogent arguments for not using a single discount rate for the entire range of the project’s cash flows. Certain projects are more or less risky than others; use of the firm’s overall (weighted average) cost of capital may or may not be appropriate for a given project. Furthermore, the use of the same discount rate for all projects would lead to favoring riskier projects, as their cash flows would be inadequately discounted; the discount rate for riskier projects’ cash flows would be higher than it should be if we adjust for risk. The NPV would, therefore, be overstated – before adjusting for risk.
Indeed, certain cash flows – within a given project – may be more or less risky than other cash flows. Herewith we have not provided a means by which the variable riskiness of numerous cash flows may be differentiated.