Question

Which of the following statements about MIRR is TRUE?

a) For a project with one initial cash outflow followed by a series of positive cash inflows, the modified IRR (MIRR) method involves compounding the cash inflows out to the end of the project's life, summing those compounded cash flows to form a terminal value (TV), and then finding the discount rate that causes the PV of the TV to equal the project's cost.
b) When evaluating mutually exclusive projects, the modified IRR (MIRR) always leads to the same capital budgeting decisions as the NPV method, regardless of the relative lives or sizes of the projects being evaluated.
c) Both the regular and the modified IRR (MIRR) methods have wide appeal to professors, but most business executives prefer the NPV method to either of the IRR methods.
d) Modified internal rate of return (MIRR) is a supeior method of capital budgeting comparing to the internal rate of return (IRR) method because MIRR assumes that cash inflows and outflows are reinvested and discounted at the same rate, the project's required rate of return.

Answer 1

The modified internal rate of return (MIRR) method is considered superior to the internal rate of return (IRR) because MIRR assumes reinvestment of cash inflows and outflows at the project's required rate of return. This method mitigates the issues associated with the IRR by addressing the assumed reinvestment rate discrepancy. Thus option d is correct.

Step-by-step explanation:

The Modified Internal Rate of Return (MIRR) is a method used in capital budgeting to address the shortcomings of the traditional Internal Rate of Return (IRR). Statement (d) accurately highlights one of MIRR's key advantages over IRR. The IRR method assumes reinvestment at the IRR, often leading to unrealistic reinvestment rate assumptions. However, the MIRR assumes that cash flows, both inflows, and outflows, are reinvested at the project's cost of capital, which is more practical and reflects the project's true earning potential.

Conversely, Statement (a) describes the Net Present Value (NPV) methodology rather than MIRR. NPV calculates the present value of all cash inflows and outflows discounted at a predetermined required rate of return. Statement (b) is incorrect as MIRR and NPV may yield different decisions for mutually exclusive projects, particularly when the cash flows and project durations vary significantly.

Finally, Statement (c) reflects an opinion regarding the preference of capital budgeting methods among academics and business practitioners rather than an assertion about the specific characteristics of MIRR.

In conclusion, MIRR's superiority over IRR lies in its consideration of a more realistic reinvestment rate assumption, aligning with the project's required rate of return, which effectively addresses one of the major criticisms of the traditional IRR method.

Thus option d is correct.