Question

Describe the Modified Internal Rate of Return (MIRR) method for determining a capital

budgeting project's desirability. What are MIRR's strengths and weaknesses? Explain the

differences in the reinvestment rate assumption that distinguishes MIRR from IRR.

Answer 1

Modified Internal Rate of Return (MIRR)

Modified internal rate of return is a modification of internal rate of return (IRR). It works on the premise that all project cash flows are discounted at the cost of capital and they are reinvested at the reinvestment rate.

Strengths of Modified Internal Rate of Return:

1. All cash flows are reinvested at the reinvestment rate and is much more realistic than internal rate of return where the cash flows were reinvested at the IRR.
2. The method of calculation eliminates the possibility of multiple IRRs for projects with abnormal cash flows.

Weaknesses of Modified Internal Rate of Return:

1. It gives conflicting decisions with NPV. It could be because of differences in timing of cash flows and the size of the project.
2. It requires the calculation of the financing rate and the cost of capital. These need to be estimated and managers may hesitate to use these rates.

3. The internal rate of return assumes that the cash flows are reinvested at the internal rate of return. It therefore, excludes the cost of capital and inflation. This leads to inaccurate decision and paints an unrealistic picture.

Modified internal rate of return assumes that the cash flows are reinvested at the reinvestment rate. It gives accurate decisions.

I hope that was helpful :)