Which statement is true about the internal rate of return (IRR) in relation to cash flow reinvestment?

• A. IRR assumes all cash flows are reinvested at the project's NPV.
• B. IRR ignores reinvestment of cash flows.
• C. IRR is the annualized rate of return including cash flows reinvested.
• D. IRR is simply the initial yield if all cash flows are kept as cash.

Answer: (C)

The idea being tested is how IRR treats cash inflows after they’re received. IRR is the rate that makes the project’s NPV zero, and you can interpret it as the annualized return you would earn if every interim cash flow is reinvested at the IRR itself. That reinvestment-at-IRR interpretation is what makes this statement true: the IRR reflects an annualized return assuming reinvestment at the IRR rate.

That’s why the other options don’t fit. Reinvesting at the project’s NPV isn’t a defined reinvestment rate, so that notion is incorrect. IRR does not ignore reinvestment; it implicitly assumes reinvestment at the IRR. And it isn’t simply the initial yield if all cash flows are kept as cash, since IRR involves compounding returns from reinvested cash flows. In practice, some analysts use MIRR to allow a different reinvestment rate, but for IRR itself, the reinvestment at IRR interpretation is the key.