Modified Internal Rate of Return

Despite a strong academic preference for NPV, surveys indicate that many business executives prefer IRR. It seems that many managers find it intuitively more appealing to analyze investments in terms of percentage rates of return (IRR) rather than dollars (NPV). However, remember from our earlier discussion that the IRR method assumes the cash flows from the project are reinvested at a rate of return equal to the IRR, which we generally view as impractical. Given this fact, can we devise a rate of return measure that is better than the regular IRR? The answer is yes: We can modify the IRR and make it a better indicator of relative profitability, hence better for use in capital budgeting. This modified return is called the modified IRR, or MIRR, and it is defined as follows:

PV of cash outflows=TV(1+MIRR)n

The term on the left side of the equals sign is simply the present value (PV) of all the investment outlays (cash outflows) when discounted at the firms required rate of return, r, and the term on the right side of the equals sign is the future value of all the cash inflows, assuming that these inflows are reinvested at the firms required rate of return. The future value of the cash inflows is also called the terminal value, or TV. The discount rate that forces the PV of the TV to equal the PV of the costs is defined as the MIRR.*

We can illustrate the calculation of MIRR with Project S:

To determine whether a project is acceptable using the MIRR technique, we apply the same decision rule used for IRR; thus, the MIRR decision rule is:

Accept if MIRR>r

Using the cash flows as set out on the cash flow timeline, first find the terminal value by compounding each cash inflow at the 10 percent required rate of return. Then, enter into your calculator PV=-3,000, which is the present value of the projects cash outflows, FV=4,628.50, which is the future value of the projects cash inflows, and N=4; compute I/Y=11.4%=MIRRS. Using the same process, we find MIRRL=11.0%.

Problem:

What is the internal rate of return (IRR) for a project that costs $9,330 and is expected to generate $2,900 per year for the next five years?

If the firms required rate of return is 8.5 percent, what is the projects modified internal rate of return (MIRR)?

Should the firm purchase the project?