Question

What is the correction that is made to the IRR method when using the Modified IRR method?

Answer 1

IRR and Modified IRR are capital budgeting techniques that help an investor to understand how attractive an investment is. However, there are certain drawbacks in the IRR method that are corrected when using the Modified IRR method. The corrections made to the IRR method when using the Modified IRR method are:

1. The IRR method of computing rate of return on a project or investment considers only the internal factors and does not focus on the cost of capital. The Modified IRR method, on the other hand, takes the cost of capital into consideration. The assumption made in the IRR method is that the cash flows from a project are reinvested at the IRR itself while the Modified IRR method assumes that the positive cash flows are reinvested at the firm's cost of capital and that the negative cash flows or initial investment are financed at the financing cost of the company. Therefore, an investor can evaluate more accurately by using the Modified IRR method.

2. The IRR method has another issue of providing multiple solutions for the same project. This is because trial and error method along with interpolation technique is used to compute IRR. The process of trial and error continues until we arrive at that particular discount rate at which the present value of the net cash inflow from the project is just equal to initial cost of the project. In other words, we have to arrive at that discount rate where Net Present Value (NPV) is equal to zero. The Modified IRR method, on the other hand, eliminates this issue by providing only a single solution for a particular project. The formula for Modified IRR is:

Where, n = number of periods

FV = Future Value

PV = Present Value