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 projects IRR.

Consider the following situation:

Celestial Crane Cosmetics is analyzing a project that requires an initial investment of $400,000. The projects expected cash flows are:

Year Cash Flow

Year 1 $375,000

Year 2 100,000

Year 3 450,000

Year 4 425,000

Celestial Crane Cosmeticss WACC is 7%, and the project has the same risk as the firms average project. Calculate this projects modified internal rate of return (MIRR):

23.51%

33.80%

29.39%

30.86%

If Celestial Crane Cosmeticss 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.