Question

Discuss the concept of Internal Rate of Return (IRR). What is it and how is it used by companies. What is the modified internal rate of return (MIRR)? Give an example of each.

Answer 1

Internal rate of return (IRR) is the interest rate at which the net present value of all the cash flows ( positive or negative ) from a project or investment equal zero.

Internal rate of return is used to evaluate the attractiveness of a project or investment. If the IRR of a new project exceeds a company's required rate of return, that project is desirable. If IRR falls below the required rate of return, the project should be rejected.

Example to illustrate how to use IRR

Assume Company ABC must decide whether to purchase a piece of factory equipment for $300000. The equipment would only last 3 years, but it is expected to generate $150000 of additional annual profit during those years. Company ABC also thinks it can sell the equipment for scrap afterward for about $10000. Using IRR, Company ABC can determine whether the equipment purchase is a better use of its cash than its other investments options, which should return about 10%.

Modified Internal Rate of Return is a revised version of the internal rate of return ( IRR ), Which calculates the reinvestment rate and accounts even or uneven cash flows.

If the MIRR IS Higher than the expected return, the investment should be undertaken, If the MIRR is lower than the expected return, the project should be rejected. Also, if two projects are mutually exclusive, the project with the higher MIRR should be undertaken.