Question

“Bankrupt” Corporation is in a deep financial crisis. You are one of the financial avengers “Bankrupt” is desperately seeking help from. CEO of the company informed you that he is considering the two risky projects “Thanos” and “Loki” to protect the firm from financial collapse. Both projects have similar risk characteristics. Bankrupt’s WACC is 11%. The initial investments for both the projects are $200 million. Cashflow from the projects are as follows;

Year           1                2                3                4

Thanos       10M           60M           80M           160M

Loki           70M           50M           20M           160M

Now, your job is to explain the following questions in great detail so that the CEO understands your plans to protect the firm.

1. WACC has increased to 15%. What change you will see in IRR? Is it good for the firm?
2. What is the reinvestment assumption for NPV and IRR? Why NPV is better than IRR?
3. Find the MIRR for both projects and explain the difference with IRR.
4. Is MIRR a better measure than NPV? Why and why not?

Answer 1

1. When the WACC for the company has increased from 11% to 15%, the NPV of the company has reduced. IRR or Internal Rate of Return is the rate at which the Present Value of Cash Inflows= Present Value of Cash Outflows. The change in WACC for the company will affect the IRR of the company.If IRR is greater than WACC, the project's rate of return will exceed it's cost and as a result the project will be accepted. and if the IRR is less than WACC, the project's rate of return will not exceed it's cost and as a result the project will be rejected. But the increase in WACC rate is not beneficial for the company since it leads to a decrease in NPV for the company under both the projects.

2.The IRR has a reinvestment assumption that assumes that the company will reinvest cash inflows at the IRR's rate of return for the lifetime of the project.If this reinvestment rate is too high to be feasible, then the IRR of the project will fall.

The NPV or the Net Present Value has no reinvestment assumption, therefore the reinvestment rate will not change the outcome of the project.

NPV is better than IRR for assessing the feasibility of the project. The IRR or the Internal Rate of Return is the rate where the Present Value of Cash Inflows=Present Value of Cash Outflows, whereas the NPV or the Net Present Value helps to determine whether the project will produce profits for the company or not. Thus, NPV is a better form of measurement for the feasibility of the project.

3. Computation of MIRR or Modified Internal Rate of Return for both the projects.

MIRR for Thanos= 2.58%

MIRR for Loki = 2.81%

Even though the IRR metric is popular among business managers, it tends to overstate the profitability of a project and can lead to capital budgeting mistakes based on an overly optimistic estimate. The modified internal rate of return (MIRR) compensates for this flaw and gives managers more control over the assumed reinvestment rate from future cash flows.

Another major issue with IRR occurs when a project has different periods of positive and negative cash flows, In these cases, the IRR produces more than one number, causing uncertainity and confusion. MIRR solves this issue as well.

The points given below are substantial so far as the difference between IRR and MIRR is concerned:

a.Internal Rate of Return or IRR implies a method of reckoning the discount rate considering internal factors, i.e. excluding the cost of capital and inflation. On the other hand, MIRR alludes to the method of capital budgeting, which calculates the rate of return taking into account cost of capital. It is used to rank various investments of the same size.

b.The internal rate of return is an interest rate at which NPV is equal to zero. Conversely, MIRR is the rate of return at which NPV of terminal inflows is equal to the outflow, i.e. investment.

c.IRR is based on the principle that interim cash flows are reinvested at the project’s IRR. Unlike, under MIRR, cash flows apart from initial cash flows are reinvested at firm’s rate of return.

d.The accuracy of MIRR is more than IRR, as MIRR measures the true rate of return.

4. The internal rate of return is an interest rate at which NPV is equal to zero. Conversely, MIRR is the rate of return at which NPV of teminal inflows is equal to the outflow, i.e. investment . IRR is based on the principle that interim cash flows are reinvested at the project's IRR.Thus, NPV is a better measure of feasibility of a project.