Final answer:
MIRR differs from IRR because it accounts for the reinvestment of cash flows at the reinvestment rate and initial investments at the finance rate, making it a more accurate measure of an investment's profitability.
Step-by-step explanation:
The Modified Internal Rate of Return (MIRR) differs from the traditional Internal Rate of Return (IRR) in a few key ways. Firstly, the MIRR takes into account the reinvestment of cash flows, whereas the IRR assumes that all cash flows are reinvested at the internal rate of return itself. Secondly, MIRR applies a single discount rate to account for the cost of capital, which resolves multiple IRR issues seen with non-normal cash flows. The MIRR is calculated by first finding the future value of the positive cash flows reinvested at the reinvestment rate, and then finding the present value of these future amounts at the finance rate (the cost of capital). Finally, MIRR is found by solving the equation where the present value of outflows equals the present value of inflows.
As for the options provided, option b is the most accurate: MIRR uses a reinvestment rate for future cash flows and a finance rate for initial investment, while IRR assumes all cash flows are reinvested at the IRR itself. This makes MIRR a more accurate reflection of an investment's profitability, as it considers the cost of capital and the likely reinvestment rate, which is often not equal to the IRR.
In the example regarding bond prices and interest rates, changes in the interest rate affect the present value of future cash flows. When interest rates rise, the present value of the cash flows decreases, which means that the investment's value falls. This concept of discounting cash flows at a higher rate, as seen in the example, is pertinent to understanding how MIRR incorporates a more realistic approach to evaluating an investment's worth.