Question

Grey company is analyzing a project that requires an initial investment of $600,000. The project's expected cash flows are: (Year 1) $350,000, (Year 2) -$125,000, (Year 3) $500,000 and (Year 4) $400,000.

1. Grey company's WACC is 10%, and the project has the same risk as the firm's average project. Calculate this project's modified internal rate of return (MIRR): _______%.

2. If Grey company's managers select projects based on the MIRR criterion, they should accept or reject this independent project.

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

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.

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.

Answer 1

MIRR and IRR calculation requires use of Excel or Financial Calculator.

Q1. MIRR = 19.12%

Q2. Given MIRR > WACC of project, you should select the project.

MIRR greater than WACC means the returns generated by project's cash flows are higher than the cost of capital applied for the project. Since returns are greater than cost, accept the project

Q3. Statement 3 is correct - 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.

IRR method has a disadvantage associated wit it that all cash flows generated are reinvested at same return as IRR. However, this is not the corect assdumption in real world and this disadvantage can be mitigated by using MIRR instead of IRR.