Finance Term Paper

 

 

The IRR is still the most popular DCF method of investment appraisal used in industry. The IRR is a truly addictive method. The modified internal rate of return (MIRR) is calculated as follows. First, compound all future cash flows to a net terminal value using the market's risk adjusted rate of return. Second, the MIRR is the rate of interest per period that equates the net terminal value with the initial cost.
 

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The process required to obtain the MIRR begs the question of why not just rely on the NPV signal? There are reasons to believe that NPV is easier to calculate than MIRR. The first step of an NPV analysis is to discount all future cash flows to present values--MIRR uses compounding. The second step is to add up the present values--MIRR requires the geometric average to be calculated.

We know that the IRR and NPV methods generate the same ranking signal in specific circumstances. The problem with the IRR signal is that it is not directly obvious when conflict with the NPV method is present. The argument that the NPVs should also be calculated to ensure that the IRRs are generating the correct signal is, of course, totally ridiculous. Why not just rely on the NPV method in the first place?

The MIRR suffers from all of the defects of the IRR method with the exception of the multiple roots problem. Such an outcome should not be surprising. Would you really expect a modification specifically designed to correct one problem to also always overcome all other defects? We can see little benefit in dragging the reader through the pitfalls of the MIRR method.
It can be shown that MIRR will rank two, or more, projects the same way as the NPV method if the projects have:
(i) The same initial cost at time zero and
(ii) The same systematic risk, i.e. command the same discount rate and
(iii) The same economic life.

Consider the projects as described in the chapters. Both projects have two IRRs and the same NPV at a discount rate of 20%. With normal projects, the NPV decreases with an increase in the discount rate. It is instructive to observe that the MIRR increases (at a decreasing rate), for both projects, with the risk-adjusted discount rate. Such a result gives the distinct appearance of being contrary to common sense. Whether this perverse result is just a consequence of the projects we have chosen to inspect is largely irrelevant. The point is that the MIRR statistic, in isolation, just cannot tell us whether or not the following problem is present.

 

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The MIRR of second project is always higher than the MIRR of first project for all discount rates greater than zero. Indeed, the difference between the two MIRRs is a positive function of the discount rate. However, the NPV of project Y is less than the NPV of project X for all discount rates less than 20%. Thus it can be easily observed that a conflict arises between MIRR and NPV when the discount rate is less than 20%. Thus we must conclude that the MIRR suffers from the very same defect, as does the IRR. Besides, compared to the IRR, the MIRR is more biased towards projects with large initial cash inflows at any discount rate above the IRR. It is instructive to note that our example is but a variant of the classical NPV versus IRR conflict presented in finance texts. The fact that our examples contain two IRRs is but a gloss. A conflict has the potential to arise even if the negative cash flows in period 2 were replaced by positive cash flows.

We feel it is unfair to blame the poor performance of the IRR method on the reinvestment assumption. The reinvestment of the intermediate cash flows at the IRR is not implied in the use of this method. Indeed, as an inspection of the IRR method clearly shows, the IRR is just a function of the time and size of the cash flows. The intermediate cash flows could be invested wisely or they could be squandered. Whatever their destiny, the IRR remains unchanged. The IRR has a sound economic meaning. It is the rate of return earned by the project. Sadly, however, it has more defects than the fleas on a hedgehog when it comes to the ranking of projects. MIRR has been offered to wean practitioners off the IRR method. However, any belief that the MIRR method will be superior to the IRR method is truly a pipe dream. If financial decision makers are not aware of the defects of Internal Rate of Return methods, whether modified or not, then the future does not look very good for the economy.


 

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