Question

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:

Cute Camel Woodcraft Company is analyzing a project that requires an initial investment of $450,000. The project’s expected cash flow are:

Year	Cash Flow
Year 1	$275,000
Year 2	–125,000
Year 3	500,000
Year 4	500,000

Cute Camel Woodcraft Company’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):

A. 26.48%

B. 21.18%

C. 22.51%

D. 25.16%

If Cute Camel Woodcraft Company’s managers select projects based on the MIRR criterion, they should______(ACCEPT/REJECT) this independent project.

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

A. 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.

B. 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.

C. 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.

Answer 1

The Modified Internal rate of return method rectifies the key flaw of the IRR method ,which is the underlying assumption.The MIRR method assumes that the project's cash flow are reinvested at the cost of capital.this is a realistic assumption

Here the MIRR can be computed using the excel function=MIRR()

The formula used =MIRR(B2:B6,10%,10%)

We get the MIRR as 26.48%

so the MIRR is (A) 26.48%

Answer to second part

When MIRR is used as a criterion projects with MIRR greater than the cost of capital are accepted.here the MIRR is greater than the cost of capital

So if Cute Camel Woodcraft company's managers selects projects based on MIRR criterion they should accept this independent project.

Answer to the 3rd part

Correct option

A. 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.

Other options explained

the IRR method uses the PV of initial investment to compute IRR the MIRR method uses the terminal value of initial investment to calculate MIRR

This is false.Both methods consider the entire cash flows

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.

False.Both Methods use the entire cash flows to compute the IRR.So this statement is false.