Question

4. 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: Grey Fox Aviation Company is analyzing a project that requires an initial investment of $600,000. The project’s expected cash flows are: Year Cash Flow Year 1 $375,000 Year 2 –125,000 Year 3 425,000 Year 4 475,000 Grey Fox Aviation Company’s WACC is 7%, and the project has the same risk as the firm’s average project. Calculate this project’s modified internal rate of return (MIRR): 16.47% 21.96% 18.30% 20.13% If Grey Fox Aviation 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? 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. 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 uses only cash inflows to calculate the IRR. The MIRR method uses both cash inflows and cash outflows to calculate the MIRR

Answer 1

MIRR is calculated using MIRR function in Excel. MIRR is 18.30%.

fac =MIRR(B2:B6,7%,7%) D E C 2 AB 1 Year Cash Flow 0 ($600,000) 1 $375,000 2 ($125,000) 3 $425,000 4 $475,000 7 MIRR 18.30%)

If Grey Fox Aviation Company’s managers select projects based on the MIRR criterion, they should accept this independent project. This is because MIRR is higher than WACC.

The MIRR method assumes that cash flows are reinvested at a rate of return equal to the cost of capital.