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:

Green Caterpillar Garden Supplies Inc. is analyzing a project that requires an initial investment of $2,500,000. The project’s expected cash flows are:

Year	Cash Flow
Year 1	$350,000
Year 2	–200,000
Year 3	425,000
Year 4	400,000

Green Caterpillar Garden Supplies Inc.’s WACC is 8%, and the project has the same risk as the firm’s average project. Calculate this project’s modified internal rate of return (MIRR):

24.31%

19.25%

16.21%

-16.48%

If Green Caterpillar Garden Supplies Inc.’s managers select projects based on the MIRR criterion, they should (reject or accept) this independent project.

Which of the following statements about the relationship between the IRR and the MIRR is correct?

A typical firm’s IRR will be equal to its MIRR.

A typical firm’s IRR will be less than its MIRR.

A typical firm’s IRR will be greater than its 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=350,000*(1.08)^3+425000*(1.08)+400,000

=$1299899.2

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

=2,500,000+200,000/1.08^2

=$2671467.76

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

=[1299899.2/2671467.76]^(1/4)-1

=-16.48%(Approx)(Negative)

Hence since MIRR is negative;they should reject this independent project.

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

A typical firm's IRR will be greater than its MIRR.