Question

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:

Green Caterpillar Garden Supplies Inc. is analyzing a project that requires an initial investment of $2,500,000. The project’s expected cash flows are:

Year	Cash Flow
Year 1	$350,000
Year 2	–125,000
Year 3	500,000
Year 4	475,000

Green Caterpillar Garden Supplies 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):

26.25%

30.39%

-13.28%

31.77%

If Green Caterpillar Garden Supplies Inc.’s managers select projects based on the MIRR criterion, they should REJECT/ACCEPT this independent project.

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

A typical firm’s IRR will be less than its MIRR.

A typical firm’s IRR will be greater than its MIRR.

A typical firm’s IRR will be equal to its MIRR.

Answer 1

Cash Flows:
Year 0 = -$2,500,000
Year 1 = $350,000
Year 2 = -$125,000
Year 3 = $500,000
Year 4 = $475,000

WACC = 9%

Present Value of Cash Outflows = $2,500,000 + $125,000/1.09^2
Present Value of Cash Outflows = $2,605,209.999

Future Value of Cash Inflows = $350,000*1.09^3 + $500,000*1.09 + $475,000
Future Value of Cash Inflows = $1,473,260.15

MIRR = (Future Value of Cash Inflows / Present Value of Cash Outflows)^(1/Period) - 1
MIRR = ($1,473,260.15 / $2,605,209.999)^(1/4) - 1
MIRR = 0.565505^(1/4) - 1
MIRR = 0.8672 - 1
MIRR = -0.1328 or -13.28%

If Green Caterpillar Garden Supplies Inc.’s managers select projects based on the MIRR criterion, they should reject this independent project.

A typical firm’s IRR will be greater than its MIRR.