Question

# 4. Modified internal rate of return (MIRR) The IRR evaluation method assumes that cash flows from...

4. Modified internal rate of return (MIRR)

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 \$500,000. The project’s expected cash flows are:

Year

Cash Flow

Year 1 \$325,000
Year 2 –150,000
Year 3 400,000
Year 4 500,000

Cold Goose Metal Works Inc.’s WACC is 9%, and the project has the same risk as the firm’s average project. Calculate this project’s modified internal rate of return (MIRR):

21.32%

17.06%

22.39%

24.52%

If Cold Goose Metal Works Inc.’s managers select projects based on the MIRR criterion, they should(reject or accept) this independent project.

Which of the following statements best describes the difference between the IRR method and the MIRR method?

The IRR method uses the present value of the initial investment to calculate the IRR. The MIRR method uses the terminal value of the initial investment to calculate the MIRR.

The IRR method assumes that cash flows are reinvested at a rate of return equal to the IRR. The MIRR method assumes that cash flows are reinvested at a rate of return equal to the cost of capital.

The IRR method uses only cash inflows to calculate the IRR. The MIRR method uses both cash inflows and cash outflows to calculate the MIRR.