Question

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:

Fuzzy Button Clothing Company is analyzing a project that requires an initial investment of $500,000. The project’s expected cash flows are:

Year	Cash Flow
Year 1	$350,000
Year 2	–125,000
Year 3	450,000
Year 4	475,000

Fuzzy Button Clothing 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):

21.79%

20.58%

27.84%

24.21%

If Fuzzy Button Clothing Company’s managers select projects based on the MIRR criterion, they should _______ this independent project.

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

a) 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.

b) 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.

c) 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.

Answer 1

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Answer:

a)

	Cashflows
	-500000
	350000
	-125000
	450000
	475000
MIRR(C680:C684,0.1,0.1)	24.21%

b)

Since MIRR greater than Cost of capital they should accept the project

c)

IRR method assumes all cash flow are reinvested at IRR rate which is not always true but MIRR assumes all cash flow are reinvested at cost of capital of the project which seems more realistic.