The IRR should be greater than the given discount rate (cost of capital) to make a project acceptable. If IRR is less than the cost of capital then, the proposal cannot be accepted as it will lead to a negative NPV. Since, IRR is a rate of return, the project with a higher IRR is a rate of return, the project with a higher IRR should be ranked higher than the other project which has a lower IRR (Ross & Westerfield, 1996).
Why IRR is important?
It considers cash flows of projects in their entirety.
It takes into account time value of money.
It is useful in ranking of projects because it is a rate and not any absolute value.
It is independent of any externally determined rate (discount rate or cost of capital), and hence ranking of projects will not change with variation in cost of capital.
It is particularly useful as it helps a businessman and also a financer in assessing the margin of safety in a project.
It is more appealing to the businessmen who are used to thinking in terms of cost and return.
Drawbacks of IRR Methods
The IRR method is based on the assumption that the recovered funds, if not consumed in each time period, are reinvested at i% rather than at MARR. This is not always practical.
When the algebraic sum of the cash flow changes more than one in the series, it is possible to obtain multiple rates of return.
Let us consider the following cash flow
End of year
Net Cash Flow
0
-1000
1
+2300
2
-1320
From the above cash flow pattern, we find IRR =10% and 20%, but actually both of them may not be correct. In such a situation, we may compel to abandon and the IRR and use Net Present Value criteria to make decision.
IRR method does not consider the scale of investment. Therefore, it can be misleading when choosing between mutually exclusive projects that have substantially different outlays.
For example,
Both projects are accepted at MARR=12% but project B with higher PW is more wrathful to the Stake holders, whereas from IRR point of view, project A seems better. Hence, IRR method is unsuitable for ranking projects of different scale of investment.
MODIFIED INTERNAL RATE OF RETURN (MIRR):
Why MIRR?
Internal rate of return is a good measure of profitability of a given project proposal. However, it suffers from an important drawback. It assumes that a project’s cash inflows are reinvested at the projects IRR. This may actually not be true. It is more reasonable to assume that a project’s cash flows are reinvested either at the cost of capital or any other rate at which opportunities of investment are available (which is usually lower than the IRR). With this assumption a modification in IRR is often suggested and this rate is called Modified Internal Rate of Return or MIRR; In this method we first calculate the terminal value of cash inflows at the cost of capital (or some other more realistic rate) and then discount it at a rate which will equalize its value with the present value of initial investment (Balyeat & Cagle, 2013).
How to calculate a MIRR of project:
Year
CF
0
-1200
1
300
2
350
3
450
4
500
Assuming the cost of capital at 10%
The Modified Internal Rate of Return (MIRR) is calculated as follows:
Decision: The MIRR is greater than cost of capital so that this project is Accepted.
Why MIRR is Important in capital budgeting?
It does not need trial and error process to solve for i%
There is no possibility of multiple rate of return.
References
Balyeat, R., & Cagle, J. (2013). Teaching MIRR to Improve Comprehension of Investment Performance Evaluation Techniques. JOURNAL OF ECONOMICS AND FINANCE EDUCATION ∙ Volume 12∙ Number 1 .
Ross, S., & Westerfield, R. (1996). Essentials of Corporate Finance. Irwin .
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How is Internal Rate of Return calculated?
The IRR should be greater than the given discount rate (cost of capital) to make a project acceptable. If IRR is less than the cost of capital then, the proposal cannot be accepted as it will lead to a negative NPV. Since, IRR is a rate of return, the project with a higher IRR is a rate of return, the project with a higher IRR should be ranked higher than the other project which has a lower IRR (Ross & Westerfield, 1996).
Why IRR is important?
Drawbacks of IRR Methods
Let us consider the following cash flow
From the above cash flow pattern, we find IRR =10% and 20%, but actually both of them may not be correct. In such a situation, we may compel to abandon and the IRR and use Net Present Value criteria to make decision.
IRR method does not consider the scale of investment. Therefore, it can be misleading when choosing between mutually exclusive projects that have substantially different outlays.
For example,
Both projects are accepted at MARR=12% but project B with higher PW is more wrathful to the Stake holders, whereas from IRR point of view, project A seems better. Hence, IRR method is unsuitable for ranking projects of different scale of investment.
MODIFIED INTERNAL RATE OF RETURN (MIRR):
Why MIRR?
Internal rate of return is a good measure of profitability of a given project proposal. However, it suffers from an important drawback. It assumes that a project’s cash inflows are reinvested at the projects IRR. This may actually not be true. It is more reasonable to assume that a project’s cash flows are reinvested either at the cost of capital or any other rate at which opportunities of investment are available (which is usually lower than the IRR). With this assumption a modification in IRR is often suggested and this rate is called Modified Internal Rate of Return or MIRR; In this method we first calculate the terminal value of cash inflows at the cost of capital (or some other more realistic rate) and then discount it at a rate which will equalize its value with the present value of initial investment (Balyeat & Cagle, 2013).
How to calculate a MIRR of project:
Assuming the cost of capital at 10%
The Modified Internal Rate of Return (MIRR) is calculated as follows:
Terminal values of inflows = 300(1.1)³ + 350(1.1)² + 450(1.1) + 500
= 1817.80
Discounted at 10%, its present value is 1241.58
Discounted at 11%, its present value is 1197.44
MIRR = 10 + (41.58) / (1241.58 - 1197.44)
= 10.94%
Decision: The MIRR is greater than cost of capital so that this project is Accepted.
Why MIRR is Important in capital budgeting?
References
Balyeat, R., & Cagle, J. (2013). Teaching MIRR to Improve Comprehension of Investment Performance Evaluation Techniques. JOURNAL OF ECONOMICS AND FINANCE EDUCATION ∙ Volume 12∙ Number 1 .
Ross, S., & Westerfield, R. (1996). Essentials of Corporate Finance. Irwin .