Internal Rate of Return and Modified Rate of Return Valuation Methods - Coursework Example

IRR vs. MIRR Valuation Methods This paper talks about the two most important project evaluation technique internal rate of return (IRR) and modified rate of return (MIIR) used by managers for there decision makings. In this paper I have tried to find out the best technique to be used in the current scenario or in future that can eliminate all the pitfalls available with IRR and MIRR. This paper also deals with the argument that how MIRR is better than IRR? And we came with the conclusion that annual rate of return is a best technique that can be used in the current scenario to eliminate the pitfalls of IRR and MIRR. Whether a project should be undertaken or not is one of the most important questions that come in the mind of investor while choosing a project. Here I am going to discuss two most important techniques commonly used by the investment managers while choosing a project. Through this paper first of all I would discuss about internal rate of return (IRR) its importance (current and future) and then pitfalls. After IRR I would discuss about Modified internal rate of return (MIRR) its importance (current and future) and its pitfalls. After discussing IRR and MIRR, I would discuss the better technique currently in use to tackle the pitfalls of IRR an MIRR. Internal Rate of Return Internal rate of return can be defined as a discount rate that makes the present value of all expected future cash flows equal to zero. IRR is most favored technique among the investors after net present value (NPV). The decision rule for the internal rate of return suggests the investor to choose a if its internal rate of return is greater than the cost of capital. The cost of capital, in the context of the IRR, is a minimum acceptable rate of return to choose the project. (Fabozzi, 2003) Table 1: Decision rule – Internal rate of return (IRR) If That means Decision IRR > Cost of Capital This indicates that investment is expected to return more than required The project should be accepted. IRR < Cost of Capital This indicates that investment is expected to return less than required The project should be rejected. IRR = Cost of Capital This indicates that investment is expected to return what is required Should be indifferent between accepting or rejecting the project. Internal Rate of Return as an Evaluation Technique Following is the method that talks about how internal rate of return technique heaps up against the three criteria. 1. IRR and All Cash Flows 2. IRR and Timing of Cash Flows 3. IRR and Riskiness of Cash Flows Fabozzi (2003) urges that IRR considers all cash flow but it does not consider the timing of all cash flow. Also the calculation of IRR doesn’t consider risk but when we compare a project’s IRR with its cost of capital that is, applying the decision rule the risk is considered. IRR and Owners’ Wealth Maximization It has been fount out that if IRR technique is used in the projects evaluation; it helps the investor to maximize the wealth for (i) independent projects, and (ii) Capital rationing free projects. As far as mutually exclusive projects or capital rationing is concerned, the IRR may but not always lead to projects lead to projects that help the investors to maximize there wealth. IRR pitfalls As I talked earlier IRR is the most common way of measuring performance of both private equity investments and corporate projects for an investor. But IRR has some pitfall that can not be ignored while selecting profitable projects, these pitfall includes: A major pitfall: Reinvestment assumption As we know that IRR equals the effective rate of return if and only if intermediary dividends are reinvested at the IRR rate. This indicates that the spread between IRR and the effective rate of return is positive when IRR is high, and large and the spread between IRR, the performance measure, and the effective rate of return, what is of interest to investors, is negative and large when IRR is low,. Phalippou (2007) suggests the consequences of using IRR as proxy for performance of private partnership is less known. If IRR is used as as a proxy for performance level for private partnership it could be misleading for an asset class that is volatile and has intermediary cash flows. Also Phalippou (2007) suggest that the second consequence, if IRR is used as a performance evaluation tool for private partnership, is the performance appears more dispersed than its reality. Aggregation issues Also according to Phalippou (2007), another important pitfall for IRR when used as a performance measure is that the average IRR is found to be different than the IRR of the aggregated cash flows appears. It is found that an average IRR is above a benchmark but if an investor invests in fund, IRR can underperformed the benchmark. This bias could be a relatively small upward or downward bias. As far as private equity is concerned, aggregation of IRR is a dramatic issue because performance is negatively related to duration. Endogenous cash flows Phalippou (2007) also suggests that, on of the most important issue with IRR as a measure of performance measure for private partnerships that IRR provides incentive to the managers to strategically time their cash flows. Looking towards these pitfalls it has become an important issue to find out that how IRR as a performance measure provides an incentive to the managers. Fund managers generally use IRR flaws to improve the performance of their portfolio artificially and it has an adverse impact on the investors as far as it is not known to them. Based on these pitfall suggested by Phalippou (2007), modified version of IRR looks appropriate to solve major pitfalls of IRR. Modified Internal Rate of Return The modified internal rate of return (MIRR) is a modified version of IRR technique but this technique is known for using more realistic reinvestment assumption. As it can is know known that IRR has some major flows and its use can has an adverse impact on the performance of the investor portfolio. To tackle with this situation modified return is considered. Modified rate of return breaks down the return into its two components: 1. The return if there is no reinvestment, and 2. The return from reinvestment of the cash inflows. There are three steps to calculate MIRR, these steps include: 1. Use reinvestment rate as a discount rate to calculate the present value of all cash outflows. 2. Then calculate future value of all cash inflows reinvested at some rate. 3. Now solve for MIRR that causes future value of cash inflows to equal present value of outflows: Modified Internal Rate of Return Decision Rule Fabozzi (2003) suggests that the modified internal rate of return is a return on the investment, assuming a particular return on the reinvestment of cash flows. If MIRR is greater than the cost of capital the project should be accepted and if it is less than the cost of capital, the project does not provide a return commensurate with the amount of risk of the project. Table 2 Decision rule – Modified rate of return (MIRR) If That means Decision MIRR > cost of capital This indicates that investment is expected to return more than required Should accept the project. MIRR < cost of capital This indicates that investment is expected to return less than required Should reject the project. MIRR = cost of capital This indicates that investment is expected to return what is required Should be indifferent between accepting or rejecting the project. Evaluation technique for Modified Internal Rate of Return Modified rate of return technique can be assessed based on its effect on following three criteria. 1. MIRR and All Cash Flows 2. MIRR and the Timing of Cash Flows 3. MIRR and the Riskiness of Cash Flows Fabozzi (2003) urges that MIIR considers all cash flow and at the same time it also consider the timing of cash flows but still it may not produce the decision that maximizes owners’ wealth. If reinvested cost of capital for a cash flow and the costs of capital are different, the calculated MIRRs would be different for different terminal values. And then if the cost of capital is compared with the project’s MIRR a project that can increase the shareholder’s wealth can be determined. We can say that MIRR can be used to distinguish between the investments, but choosing the investment with the highest MIRR may not give the value maximizing decision for the shareholder. MIRR Pitfalls Rousse (2008) urges that when costs of capital differ between projects it is found out that the MIRR does not have a capacity to rank projects consistently with the PI and the NPV. As the cost of capital likely to remain different for different projects and due to this reason this drawback of MIRR can reduce the importance of the project.. Specific current and/or future applications and its relevance to the workplace: Rousse (2008) suggest that, Annual rate of return can be used as a better measure to evaluate the projects by eliminating the drawbacks of IRR and MIRR as it is an improvement and it also has a benefit of PI. Conclusion: Looking to the above arguments we can conclude that IRR and MIRR covers most of the pit falls of previously used valuation techniques but still they suffer from important pitfalls that include the maximization of shareholders wealth. These pitfalls found under IRR and MIRR at some extent can be removed by using a technique called annual rate of return (RRR). Works Cited Fabozzi, F. J. (2003). Financial management and analysis. New Jercy: John willy and sons. Phalippou, L. (2007). The hazards of using IRR to measure performance: The case of private equity. SSRN , 1-23. Rousse, O. (2008). On the bias of yield-based capital budgeting methods. Economics Bulletin , 1-8. Read More