4 Modified internal rate of return MIRR Aa Aa The IRR evalua

4. Modified internal rate of return (MIRR) Aa Aa 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: Cold Goose Metal Works Inc. is analyzing a project that requires an initial investment of $2,750,000. The project\'s expected cash flows are: Year Cash Flo Year $300,000 Year 2-125,000 Year 3 500,000 Year 4 425,000 Cold Goose Metal works Inc.\'s WACC is 7%, and the project has the same risk as the firm\'s average project. Calculate this project\'s modified internal rate of return (MIRR) ? 17.20% ? 19.35% ? 25.80% -17.45% If Cold Goose Metal Works Inc.\'s managers select projects based on the MIRR criterion, they should independent project. Which of the following statements about the relationship between the IRR and the MIRR is correct? O A typical firm\'s IRR will be less than its MIRR. O A typical firm\'s IRR will be equal to its MIRR. O A typical firm\'s IRR will be greater than its MIRR.

Solution

We use the formula:
A=P(1+r/100)^n
where
A=future value
P=present value
r=rate of interest
n=time period.

Hence future value of inflows=300,000*(1.07)^3+500,000*(1.07)+425000

=$1327512.9

Present value of outflows=Cash outflows*Present value of discounting factor(7%,time period)

=2,750,000+125000/1.07^2

=$2859179.841

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

=[$1327512.9/2859179.841]^(1/4)-1

=(17.45%)(Approx)(Negative).

Hence since MIRR is negative;firm should reject the project.

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

Hence for typical firm IRR is greater than MIRR.