Internal Rate of Return (IRR) is the discount rate used by companies that makes the NPV of projects equivalent to zero. It is an estimated rate so the actual rate of return may differ from this rate. This rate is just like the NPV. "Generally, the internal rate of return method indicates that a project whose internal rate of return is greater than or equal to the firm’s cost of capital should be accepted, whereas a project whose internal rate of return is less than the firm’s cost of capital should be rejected. (Moyer, McGuigan, Rao, & Kretlow, 2012)”
IRR also has some flaws that can make it difficult for the managers for selecting a project. Sometimes when a project has different cash flow (positive and negative) through the years or different scale of investments are made through the years, multiple IRR will be generated in one project itself. With multiple IRR the selection decision is different as we do not have any guidelines to choose which IRR to select.
It is in these circumstances where Modified Rate of Return is calculated. This helps calculate one rate and the decision for selection is taken after. For example let us calculate NPV in discounted rate of 0%, 4%, 8%, and 12% for 4 years.
Figure 1:
Figure 2:
Figure 3:
Figure 4:
Figure 5:
These fluctuating NPV will generate numerous IRR in the X axis of the NPV profile. It is assumed that the cash flow generated in the project is reinvested but it is not clear as to what rate it should be reinvested in or if it is reinvested in the same project. Therefore for calculating the MIRR we calculate the future value of the cash flows and deduct it from the cash outlay to find the NPV. We then calculate the MIRR from this. The highest MIRR is accepted. MIRR is calculated as
MIRR = n Total Future Value of Cash flow/Cash Outlay
However MIRR is only used when there are multiple IRR. Its effectiveness in decision making is limited and so may not have financial significance.
Reference
Moyer, C. R., McGuigan, J. R., Rao, R., & Kretlow, W. J. (2012). Contemporary Financial Management. Natorp Boulevard: South-Western, Cengage Learning.
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Internal Rate of Return (IRR) is the discount rate used by companies that makes the NPV of projects equivalent to zero. It is an estimated rate so the actual rate of return may differ from this rate. This rate is just like the NPV. "Generally, the internal rate of return method indicates that a project whose internal rate of return is greater than or equal to the firm’s cost of capital should be accepted, whereas a project whose internal rate of return is less than the firm’s cost of capital should be rejected. (Moyer, McGuigan, Rao, & Kretlow, 2012)”
IRR also has some flaws that can make it difficult for the managers for selecting a project. Sometimes when a project has different cash flow (positive and negative) through the years or different scale of investments are made through the years, multiple IRR will be generated in one project itself. With multiple IRR the selection decision is different as we do not have any guidelines to choose which IRR to select.
It is in these circumstances where Modified Rate of Return is calculated. This helps calculate one rate and the decision for selection is taken after. For example let us calculate NPV in discounted rate of 0%, 4%, 8%, and 12% for 4 years.
Figure 1:
Figure 2:
Figure 3:
Figure 4:
Figure 5:
These fluctuating NPV will generate numerous IRR in the X axis of the NPV profile. It is assumed that the cash flow generated in the project is reinvested but it is not clear as to what rate it should be reinvested in or if it is reinvested in the same project. Therefore for calculating the MIRR we calculate the future value of the cash flows and deduct it from the cash outlay to find the NPV. We then calculate the MIRR from this. The highest MIRR is accepted. MIRR is calculated as
However MIRR is only used when there are multiple IRR. Its effectiveness in decision making is limited and so may not have financial significance.
Reference
Moyer, C. R., McGuigan, J. R., Rao, R., & Kretlow, W. J. (2012). Contemporary Financial Management. Natorp Boulevard: South-Western, Cengage Learning.