Question

8. 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 :

Cute Camel Woodcraft Company is analyzing a project that requires an initial investment of $3,225,000. The project's

expected cash flows are:

Year	Cash Flow
1	300,000
2	-200,000
3	400,000
4	500,000

Cute Camel Woodcraft Company's WACC is 8%, and the project has the same risk as the firm's average project.

Calculate this project's modified internal rate of return (MIRR) .

a) 14.86%

b) -21.19%

c) 13.44%

d) 11.32%

If Cute Camel Woodcraft Company's managers select projects based on the MIRR criterion, they should ACCEPT OR REJECT this independent project.

Which of the following statements about the relationship between the IRR and the MIRR is correct?

a) A typical firm's IRR will be less than its MIRR.

b) A typical firm's IRR will be greater than its MIRR.

c) A typical firm's IRR will be equal to its MIRR.

Answer 1

C0, initial cost = $3,225,000

C1, for year 1 = $300,000

C2, for year 2 = $-200,000

C3, for year 3 = $400,000

C4, for year 4 = $500,000

WACC = 8% = 0.08

future value of cash flows for restaurant(FV) = C1*(1+R)³ + C2*(1+R)² + C3*(1+R) + C4

= 300,000*(1.08)³ + 400,000*(1.08) + 500,000

= 377913.6 + 432000 + 500,000

= 1309913.6

Present value of cost , PV = -3225000 + (-200,000/(1.08)²) = -3225000 - 171467.76406 = -3396467.76406

MIRR = (future value/PV of cost)^{(1/period of investment)} -1

= (1309913.6/3396467.76406)^(1/4) - 1 = 0.211949972 = 21.19% = -21.19% ( because PV of cost was negative)

Hence correct option is b) -21.19%

If Cute Camel Woodcraft Company's managers select projects based on the MIRR criterion, they should REJECT THE PROJECT

the following statements about the relationship between the IRR and the MIRR is correct :

b) A typical firm's IRR will be greater than its MIRR