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Common myths on yield to maturity in bonds or IRR in corporate finance

Author

Listed:
  • José P. Dapena
  • Ricardo Schefer

Abstract

The yield to maturity (YTM) or internal rate of return (IRR) is a metric used in financial analysis to estimate the profitability of potential investments. Almost all finance textbooks state the following conditioning assumptions: (i) that the coupon payments can be reinvested at a rate equal to the yield to maturity, (ii) that the bond is held to maturity We show that there are two common fallacies about these assumptions, and none of them are necessary to interpret this return measure, and they may have probably arisen as a consequence of a semantic misunderstanding. The calculation of the YTM/IRR is the result of an ex ante mathematical operation focusing on current and future cash flows, regardless of the reinvestment rate, which is different from wealth accumulation. At the end of the paper we provide some numerical examples.

Suggested Citation

  • José P. Dapena & Ricardo Schefer, 2020. "Common myths on yield to maturity in bonds or IRR in corporate finance," CEMA Working Papers: Serie Documentos de Trabajo. 764, Universidad del CEMA.
    • Handle: RePEc:cem:doctra:764
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    File URL: https://ucema.edu.ar/publicaciones/download/documentos/764.pdf
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    More about this item

    Keywords

    Yield to maturity; Project evaluation; Internal rate of return; Cash flows;
    All these keywords.

    JEL classification:

    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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