Modified Internal Rate of Return

Examples of Modified Internal Rate of Return in the following topics:

• Disadvantages of the IRR Method

  • IRR can't be used for exclusive projects or those of different durations; IRR may overstate the rate of return.
  • In addition, IRR assumes reinvestment of interim cash flows in projects with equal rates of return (the reinvestment can be the same project or a different project).
  • Therefore, IRR overstates the annual equivalent rate of return for a project whose interim cash flows are reinvested at a rate lower than the calculated IRR.
  • This presents a problem, especially for high IRR projects, since there is frequently not another project available in the interim that can earn the same rate of return as the first project.
  • Modified Internal Rate of Return (MIRR) does consider cost of capital and provides a better indication of a project's efficiency in contributing to the firm's discounted cash flow.

• Multiple IRRs

  • In a series of cash flows like (−10, 21, −11), one initially invests money, so a high rate of return is best, but then receives more than one possesses, so then one owes money, so now a low rate of return is best.
  • Accordingly, Modified Internal Rate of Return (MIRR) is used, which has an assumed reinvestment rate, usually equal to the project's cost of capital.
  • It has been shown that with multiple internal rates of return, the IRR approach can still be interpreted in a way that is consistent with the present value approach provided that the underlying investment stream is correctly identified as net investment or net borrowing.
  • Apparently, managers find it easier to compare investments of different sizes in terms of percentage rates of return than by dollars of NPV.
  • Explain the best way to evaluate a project that has multiple internal rates of return

• Defining Capital Budgeting

  • The NPV is greatly affected by the discount rate, so selecting the proper rate–sometimes called the hurdle rate–is critical to making the right decision.
  • A common practice in choosing a discount rate for a project is to apply a WACC that applies to the entire firm, but a higher discount rate may be more appropriate when a project's risk is higher than the risk of the firm as a whole.
  • The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero.
  • Accordingly, a measure called "Modified Internal Rate of Return (MIRR)" is often used.
  • Payback period in capital budgeting refers to the period of time required for the return on an investment to "repay" the sum of the original investment.

• Advantages of the IRR Method

  • The internal rate of return (IRR) or economic rate of return (ERR) is a rate of return used in capital budgeting to measure and compare the profitability of investment.
  • In other words, an investment is considered acceptable if its internal rate of return is greater than an established minimum acceptable rate of return or cost of capital.
  • In addition, the internal rate of return is a rate quantity, it is an indicator of the efficiency, quality, or yield of an investment.
  • Internal rate of return is the rate at which the NPV of an investment equals 0.
  • Describe the advantages of using the internal rate of return over other types of capital budgeting methods

• Calculating and Understanding Average Returns

  • The average return of an investment can be calculated a number of ways.
  • To calculate the total ROI of an investment, simply divide the total dollar returns of the investment by the initial value.
  • Average ROI generally does not calculate the actual average rate of return, because it does not incorporate compounding returns.
  • CAGR is very useful for finding the rate of return that the investment would have to earn every year for the life of the investment to turn the initial value into the future value over the given time frame.
  • The internal rate of return (IRR) is another commonly used method for calculating the average return .

• Defining the IRR

  • IRR is a rate of return used in capital budgeting to measure and compare the profitability of investments; the higher IRR, the more desirable the project.
  • The internal rate of return (IRR) or economic rate of return (ERR) is a rate of return used in capital budgeting to measure and compare the profitability of investments.
  • It is also called the "discounted cash flow rate of return" (DCFROR) or the rate of return (ROR).
  • The internal rate of return on an investment or project is the "annualized effective compounded return rate" or "rate of return" that makes the net present value (NPV as NET*1/(1+IRR)^year) of all cash flows (both positive and negative) from a particular investment equal to zero.
  • Explain how Internal Rate of Return is used in capital budgeting

• Relationships between ROA, ROE, and Growth

  • Return on assets is a component of return on equity, both of which can be used to calculate a company's rate of growth.
  • ROA = 500,000/3,000,000 = 17% Internal growth rate = 17% x 80% = 13% ROE = 17% x (3,000,000/1,500,000) = 34% Sustainable growth rate = 34% x 80% = 27.2%
  • In review, return on equity measures the rate of return on the ownership interest (shareholders' equity) of common stockholders.
  • In terms of growth rates, we use the value known as return on assets to determine a company's internal growth rate.
  • Discuss the different uses of the Return on Assets and Return on Assets ratios

• NPV Profiles

  • The NPV Profile graphs the relationship between NPV and discount rates.
  • Thus, when discount rates are large, cash flows further in the future affect NPV less than when the rates are small.
  • When the value of the outflows is greater than the inflows, the NPV is negative.
  • A special discount rate is highlighted in the IRR, which stands for Internal Rate of Return.
  • And it is the discount rate at which the value of the cash inflows equals the value of the cash outflows.

• Modified IRR

  • The modified internal rate of return (MIRR) is a financial measure of an investment's attractiveness.
  • As the name implies, MIRR is a modification of the internal rate of return (IRR) and as such aims to resolve some problems with the IRR.
  • Firstly, IRR assumes that interim positive cash flows are reinvested at the same rate of return as that of the project that generated them.
  • The formula adds up the negative cash flows after discounting them to time zero using the external cost of capital, adds up the positive cash flows including the proceeds of reinvestment at the external reinvestment rate to the final period, and then works out what rate of return would cause the magnitude of the discounted negative cash flows at time zero to be equivalent to the future value of the positive cash flows at the final time period.
  • To calculate the MIRR, we will assume a finance rate of 10% and a reinvestment rate of 12%.

• Assessing Internal Growth and Sustainability

  • The true benefit of a high return on equity arises when retained earnings are reinvested into the company's operations.
  • We find the internal growth rate by dividing net income by the amount of total assets (or finding return on assets) and subtracting the rate of earnings retention.
  • We find the sustainable growth rate by dividing net income by shareholder equity (or finding return on equity) and subtracting the rate of earnings retention.
  • Another measure of growth, the optimal growth rate, assesses sustainable growth from a total shareholder return creation and profitability perspective, independent of a given financial strategy.
  • The study found that return on assets, return on sales and return on equity do in fact rise with increasing revenue growth of between 10% to 25%, and then fall with further increasing revenue growth rates.