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:

Blue Llama Mining Company is analyzing a project that requires an initial investment of $550,000. The project’s expected cash flows are:

Year	Cash Flow
Year 1	$300,000
Year 2	–200,000
Year 3	425,000
Year 4	400,000

Blue Llama Mining 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):

12.56%

16.05%

13.96%

13.26%

If Blue Llama Mining 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 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.

Answer 1

Solution :-

Year	Cashflow	FVF of +ve CF	PVF of -ve CF
0	($550,000)		1
1	$300,000	1.225
2	($200,000)		0.8734
3	$425,000	1.07
4	$400,000	1
Future Value of Positive Cashflows
	(300000*1.225 + 425000*1.07 + 400000)			1222250
Present Value of Negative Cashflows
	(550000*1 + 200000*0.8734)			724680

MIRR = [ ( FV of +ve CF ) / ( PV of -ve CF ) ]^1/4 - 1

MIRR = [ 1222250 - 724680 ]^1/4 - 1

MIRR = 1.1396 - 1 = 0.1396 = 13.96%

Therefore the Correct answer is (C)

If Blue Llama Mining Company’s managers select projects based on the MIRR criterion, they should Accept  this independent project.

(C)

The Correct answer is (A)

that is 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.