Question

Modified internal rate of return (MIRR)

The IRR evaluation method assumes that cash flows from the project are reinvested at the same rate equal to the IRR. However, in reality the reinvested cash flows may not necessarily generate a return equal to the IRR. Thus, the modified IRR approach makes a more reasonable assumption other than the project’s IRR.

Consider the following situation:

Celestial Crane Cosmetics is analyzing a project that requires an initial investment of $550,000. The project’s expected cash flows are:

Year	Cash Flow
Year 1	$375,000
Year 2	–200,000
Year 3	500,000
Year 4	400,000

Celestial Crane Cosmetics’s WACC is 10%, and the project has the same risk as the firm’s average project. Calculate this project’s modified internal rate of return (MIRR):

17.37%

22.20%

19.30%

16.41%

If Celestial Crane Cosmetics’s managers select projects based on the MIRR criterion, they should ....... this independent project. (ACCEPT OR REJECT)

Which of the following statements best describes the difference between the IRR method and the MIRR method?

The IRR method uses only cash inflows to calculate the IRR. The MIRR method uses both cash inflows and cash outflows to calculate the MIRR.

The IRR method assumes that cash flows are reinvested at a rate of return equal to the IRR. The MIRR method assumes that cash flows are reinvested at a rate of return equal to the cost of capital.

The IRR method uses the present value of the initial investment to calculate the IRR. The MIRR method uses the terminal value of the initial investment to calculate the MIRR.

Answer 1

We use the formula:  
A=P(1+r/100)^n
where   
A=future value
P=present value  
r=rate of interest
n=time period.

Future value of inflows=375,000*(1.1)^3+500,000*(1.1)+400,000

=$1449125

Present value of outflows=Cash flows*Present value of discounting factor(rate%,time period)

=550,000+200,000/1.1^2

=715289.256

MIRR=[Future value of inflows/Present value of outflows]^(1/time period)-1

=[1449125/715289.256]^(1/4)-1

=19.30%(Approx)

Hence since MIRR is greater than WACC;project should be accepted.

At irr,present value of inflows=present value of outflows.

Hence the correct option is:

The IRR method assumes that cash flows are reinvested at a rate of return equal to the IRR. The MIRR method assumes that cash flows are reinvested at a rate of return equal to the cost of capital.