Question

Describe the modified internal rate of return (MIRR) as a method for deciding the desirability of a capital budgeting project. What are MIRR's strengths and weaknesses?

Answer 1

MIRR is a better version of IRR as it assumes that positive cash flows are invested at a company's cost of capital. By contract IRR assumes that postive cash flows are re invested at internal rate of return. The MIRR more accurately shows the cost and profitability of the project.

MIRR = ( furure value / present value)^1/n - 1

A project is accepted if MIRR is greater than cost of capital.

Strengths:

MIRR solves two big problems in IRR calculation. First, IRR states that positive cash flows are invested at IRR which is practically impossible. MIRR assumes that cash flows are invested at cost of capital which is more realistic.

Second, IRR can have multiple solutions whereas MIRR has only 1 solution.

It takes into account all the cash flows and considers time value of money

Weaknesses:

When two projects are mutually exclusive, it may not give a solution which is value maximising.

It may not again give a value maximising solution when there is capital rationing is involved.