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is the return that can be earned on all the returns earned by the project.
Since, in practice, these rates are likely to be different, the IRR is unreliable
Choosing between mutually exclusive projects
If choosing between mutually exclusive projects one might believe that picking the one with the
higher IRR would be optimal since this gives the greatest "return".
However, a project with a high IRR is not necessarily the one offering the highest return in NPV
terms at the company's cost of capital and IRR is therefore an unreliable tool for choosing
between mutually exclusive projects.
Modified IRR
This measure has been developed to counter the above problems since it:
is unique
is a simple percentage.
It is therefore more popular with non-financially minded managers, as a simple rule can be
applied:
Method 2
To avoid having to calculate the terminal value of the project inflows, there is an alternative way
of computing MIRR which only uses present value calculations. This approach is only valid if
the cost of capital and reinvestment rate are the same.
1 + MIRR = (1+re) [PVR/PVI]1/n
where
PVR = the present value of the "return phase" of the project
PVI = the present value of the "investment phase" of the project
re = the firm's cost of capital
of a new airport in Izmir. The second relates to construction of a motorway connecting Izmir
with Ankara, the capital. Both the projects are expected to take 3 years. The applicable finance
rate is 10% and the project's cash flows in Turkish Lira are given below:
Year
0
1
2
3
Airport
(12,000,000)
6,000,000
8,000,000
4,000,000
Motorway
(18,000,000)
8,000,000
10,000,000
10,000,000
The company submitted bids for both projects because both had positive net present values.
Alev Toprak, the CEO, has asked Gkhan to recommend which project the company should
accept. Alev is a fan of the IRR approach. Gokhan, on the other hand, is worried about the
shortcomings of the IRR approach. He believes that the economy might slow down a little in
next few years and a lower reinvestment rate should be factored in. He asked you to calculate
MIRR for both the projects.
You double-check whenever and wherever possible: so you decided to calculate the MIRR using
the manual formula approach and then verify the results using MS Excel MIRR function.
Manual approach
The following table calculates the equivalent terminal cash flow for both projects:
Year
0
1
2
3
Year
0
1
2
3
Cash Flows
(12,000,000)
6,000,000
8,000,000
4,000,000
Cash Flows
(18,000,000)
8,000,000
10,000,000
10,000,000
Airport Project
FV Factor
Formula
1.16640
1.08000
1.00000
=(1+8%)^(3-1)
=(1+8%)^(3-2)
=(1+8%)^(3-3)
Motorway Project
FV Factor
Formula
1.16640
1.08000
1.00000
Terminal Value
6,998,400
8,640,000
4,000,000
19,638,400
Terminal Value
=(1+8%)^(3-1)
=(1+8%)^(3-2)
=(1+8%)^(3-3)
9,331,200
10,800,000
10,000,000
30,131,200
MIRRAirport319,638,40012,000,000117.84%MIRRAirport=19,638,40012,000,0003-1=17.84%
MIRRMotorway330,131,20018,000,000118.74%MIRRMotorway=30,131,20018,000,00031=18.74%
The motorway project should be preferred based on MIRR approach.
Microsoft Excel Function
MIRR function is used to calculate MIRR for both projects as shown in the spreadsheet below. It
uses finance rate of 10% and reinvestment rate of 8%.