Assignment 6- Week 6 - Final Project - Irr Vs Mirr Valuation Methods

IRR Vs MIRR Valuation Methods

Dr Rahul Parikh

BUS650: Managerial Finance (MAH1209A)

Dr. Charles Smith

April 8, 2012

IRR Vs MIRR Valuation Methods:

Introduction and Overview: Whenever we evaluate a method in the world of finance, we should look at whether they appropriately allocate the resources on-hand. This technique called as capital budgeting, can vastly improve the quality, and timing, of when the provided funds should be infused into a project. Such invested ventures are expected to be valuable in-line with the forecasted time. But if the finalized projects extend beyond the schedule, it will create an enormous financial, and reputational, loss to the organization, if the forecasted revenue is not realized in the given specific period. In capital budgeting, there are a variety of ways a firm can analyze the profitability of a project. Focusing on capital budgeting, certain valuation methods are emphasized more than others, so that they can help the decision making process on whether to accept the proposed project or not. Accordingly, there are four main methods of appraisal that can be used (Accounting Rate of Return, Payback, Net Present Value, and Internal Rate of Return) that can provide the reliable investment decisions (University of London External System). Ryan and Ryan's (2002) study of Fortune 1000 companies indicated that eighty five percent use NPV, 75-100% of the time in investment. Seventy-six percent of the respondents use IRR 75-100% of the time (Journal of Business management).

Thesis Statement: In this paper we will attempt an insight into two of the most popular techniques of calculating or evaluating the profitability of a project, which are the internal rate of return (IRR) or its modified internal rate of return (MIRR). We will also attempt to look into both of these methods, and analyze, their pros and cons in respect to the outcome they give. Either way, both methods are effective in evaluating the best possible scenario for whether or not the company should reject or accept a project.

Main issues in the chosen area:

Tools to Measure an Investment Decision: Over the past few decades, the Net Present Value (NPV), and the Internal Rate of Return (IRR), has emerged to the forefront, to become the most preferred choice of financial planners, to measure the financial attractiveness of investments. Their usage to study, and analyze alternatives, has grown manifold, across many domains, from equipment and real estate acquisitions, to company acquisitions; from the valuation of Information Technology projects to offshore models; and from new product introductions to close down existing product lines. The new kid on the block, which is the Modified Internal Rate of Return (MIRR), is a derived form of IRR that avoids the common IRR pitfalls, and provides a more accurate view of financial attractiveness related to a project. Cary (2008), states that "Deriving the alternative methods as functions of NPV not only gives a consistency to the capital budgeting procedures, but also shows how this approach can be used with the alternative methods, to overcome problems when comparing mutually exclusive projects that require different size investments (scale problem) or have different lives (unequal life problem)" (p.14).

1) NPV reduces future or discounts expected cash inflows, from a future project at a rate reflecting three important factors: the associated risk, inflation expected, and the need of investors to hold cash in reserve, when a better opportunity comes in. If the sum of the discounted future cash inflows is more than the initial cash required for funding, NPV is positive, and the project is financially viable. It adds value to the investor, and the firm.

2) IRR is the rate of return percentage, which can be used as the discount rate, will make the initial cash outflow equal to the sum of discounted future cash inflows. If the IRR calculated is more than the return rate expected by the investors, then the project is definitely attractive. The internal rate of return is a rate of return used in capital budgeting, to measure and compare the profitability of investments (Baker, 2000). In other words, the IRR of an investment is the interest rate at which the costs of the investment lead to the benefits of the investment. This means that all gains from the investment are inherent to the time value of money, and that the investment has a zero net present value at this interest rate (Baker, 2000). This valuation acts as a best substitute to a company's Net Present Value. In investment terms, if the IRR is greater than the discount rate, then the project should be accepted (Ross, Westerfield, Jaffe, & Jordan, 2011).

3) MIRR or Modified Internal Rate as the name implies, is a modified type of method that covers the limitations of the IRR. It follows the same path as the IRR, but goes one step ahead by including the reinvestment of the cash flows that a company does with the money it receives, in its calculations. This ensures that the budget of a project is more accurate, and the same is presented to the company's investors, and owners. The Modified IRR (MIRR) assumes that positive cash flows are reinvested at the firm's cost of capital, and the initial outlays are financed at the firm's financing cost. Therefore, MIRR more accurately reflects the cost, and profitability, of a project (www.investopedia.com).

Class activities or incidents that facilitated learning and understanding:

NPV vs. IRR: There are numerous methods that a company can employ to get capital budgeting solutions. No one method can be termed as perfect indicator of value, risk, and stakeholder wealth maximization. Each method has its advantages, and flaws. NPV which is probably regarded by academia as the most reliable indicator of a capital projects worth, doesn't provide a 'safety margin'. When evaluating two mutually exclusive projects using NPV, the results don't tell you the IRR for each project. Bosch, Montllor-Serrats, and Tarrazon (2007), agree that "The functional relation between the net present value, and the internal rate of return that we develop, is described for conventional projects, i.e., projects that present only one change of sign in their cash flow sequence" (p. 41). Depending on the size of the project, and cash inflows, one project could have a higher NPV, but a smaller safety margin; meaning a higher NPV could have a smaller IRR, and a change in cash flows from project could have a more significant impact, than the project with

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