Relevant to ACCA Qualification Paper P4
Internal rate of return (IRR) has never had a good academic press. Compared with net present value (NPV), IRR has many drawbacks: it is only a relative measure of value creation, it can have multiple answers, it’s difficult to calculate, and it appears to make a reinvestment assumption that is unrealistic. But financial managers like it. IRR expresses itself as a percentage measure of project performance; it also provides a useful tool to measure ‘headroom’ when negotiating with suppliers of funds. The question we will try to answer is whether there is an even better measure which keeps the benefits of IRR without the drawbacks.
IRR is the discount rate which delivers a zero NPV on a given project. Discounting, like compounding cash flows, assumes that not only the initial investment, but also the net cash produced by a project, is reinvested within the project as it proceeds. Thus, the IRR is also the investment/reinvestment rate which a project generates over its lifetime – and hence IRR is also known as the ‘economic yield’ on an investment.
MODIFIED INTERNAL RATE OF RETURN
Modified internal rate of return (MIRR) is a similar technique to IRR. Technically, MIRR is the IRR for a project with an identical level of investment and NPV to that being considered but with a single terminal payment. A simple example will help explain matters.
EXAMPLE 1
A project entails an initial investment of $1,000, and offers cash returns of $400, $500, and $300 at the end of years one, two and three respectively. The company’s cost of capital is 10%.