Internal Rate of Return v Modified Internal Rate of Return Valuation Methods - Essay Example

IRR v. MIRR Valuation Methods and Number Submitted A contentious debate ranges with regardto business valuations using Internal Rate of Return (IRR) and Modified Internal Rate of Return (MIRR). While common consensus suggests that MIRR is a better valuation method than IRR investment method, the overwhelming use of IRR technique in comparison to MIRR arouses considerable curiosity. MIRR method aims to overcome some of the glaring limitations that IRR presents in valuing of investment projects in organizations. However, the MIRR valuation method still exhibits a number of limitations noticeable with the use of IRR technique, for instance, its inability to value investments that are mutually exclusive. Additionally, the teaching of both IRR and MIRR in learning institutions has been a cause of concern, with claims that the IRR technique has had more attention at the expense of the MIRR valuation method. This paper focuses on analyzing IRR and MIRR with regard to major issues of concern, emerging issues, factors that have been instrumental in the understanding of IRR and MIRR in class situations, and present and future applications of the two valuation methods. Keywords: IRR (Internal Rate of Return), MIRR (Modified Internal Rate of Return), NPV (Net Present Value) Table of Contents Abstract 2 Table of Contents 3 introduction 3 Main issues in IRR 4 Main issues in MIRR 6 New Learning in IRR 6 New Learning in MIRR 7 Class activities that have facilitated learning and understanding of IRR and MIRR 8 Specific current and future applications and 8 relevance in the workplace 8 Conclusion 10 References 11 introduction The pertinent question in the discussion about IRR and MIRR valuation methods lies in the differences that exist between the two investment appraisal methods. The chief difference in IRR and MIRR valuation methods is traceable to the factors that come into play when calculating the value of an investment with either of the methods. More specifically, the IRR valuation methods, which is more traditional form of the two, measures the worth of an investment with emphasis on internal factors, conspicuously overlooking the impact of interest rates and inflationary impact on the value of an investment. On the contrary, MIRR is a valuation technique that seeks to mitigate the impact of limitations brought about by IRR (Eagle, et al., 2008, p. 70). Just as the name implies, MIRR valuation method is a modification of the IRR valuation method. MIRR allows the value of the investment under query to show the impact of both future and present value of currencies at different times in the life of a project. Largely, IRR technique is an optimistic view on the value of an investment, while the MIRR is a more realistic view on the present and future value of an investment and is deemed more accurate than IRR valuation method (Kierulff, 2008, p. 328). This paper explores the variations between the IRR and MIRR valuation method at length, while taking into account the main issues surrounding the valuation techniques and the future and present applications of the methods. Main issues in IRR The major issue surrounding the IRR valuation method is the method’s inconsideration of environmental factors that have an impact on the value of an investment. The IRR approach compares the net present value of cash inflows and outflows. The point at which the negative cash flows and positive cash flows become equal is the IRR value. Another way to look at the valuation equation is the point at which the difference between cash inflows and cash outflows equate to zero. In establishing what project to undertake in a scenario where the different projects are under comparison, the project with the highest internal rate of return gets preference over the rest of the projects. Even under this consideration, the IRR value has to exceed the cost of capital rate for the project to be economically viable (Kelleher & MacCormack, 2004, p. 1). Despite its contribution to decision-making in organizations, the method incorporates inherent problems in its applications. Another limitation associable with the IRR is its inability to help management decide the best choice of investment in cases where mutually exclusive projects are under evaluation. The IRR method is restricted to decisions involving whether or not a project is worth investing in. Given these limitations, it becomes highly necessary for use of other valuation methods, for NPV (Net Present Value). It is only with NPV technique that the management can ascertain that a project offers a better investment in comparison to other investments under consideration. The NPV is a measure of the increase in shareholders wealth because of the investment in a project. IRR and NPV have a high correlation. According to Jacobs (2007, p. 1) IRR and NPV are practically the same methods of valuing investments, since they are both mathematical tools which have little ability to rank alternative projects. An additional challenge associable with the IRR method lies in its presumptions about reinvestment of cash flows generated from the choice project. IRR rests on the premise that reinvestment of cash generated from the project occurs in the same project or another project (Kelleher & MacCormack, 2004, p. 1). The assumption is oblivious to the fact that the returns from the reinvestment activities may offer less attractive investment options if they offer a lower IRR return. Analysts have noted this to be a significant loophole in the IRR technique, especially for investments that offer a high IRR. IRR typically overestimates the investment returns from interim investments. The formula below shows how to determine the IRR value; the Cn represents the cash flows, n as the times, and r as the rate of return.  = 0 Main issues in MIRR Despite many financial analysts hailing the MIRR as a more realistic investment evaluation method, many executives still favor the use of IRR. This is the main issue affecting the use of MIRR. Many business leaders consider the MIRR difficult to understand and compute (Eagle et al., 2008, p. 70). The reason for this assumption may be attributable to the fact that with MIRR valuation method, it is imperative to determine reinvestment rate. With IRR technique, this is never a necessity, with the presumption that the reinvestment rate is equal to the IRR rate. Below is a formula for MIRR, where FV means Future Value and PV is for Present Value. Another issue affecting the use of the MIRR valuation technique lies in its inability to rank projects that are mutually exclusive, just like the NPV and IRR valuation methods. Consequently, additional techniques are usually necessary to make the method appropriate in ranking such projects. In addition, MIRR technique faces drawbacks in ranking projects requiring different investment amounts. The same limitation is observable with the method when the investment funding is constrained. However, MIRR offers the added benefit of providing a more realistic valuation of a business investment in comparison to NPV and IRR (Kelleher & MacCormack, 2004, p. 2). New Learning in IRR Even though IRR valuation technique harbors a number of limitations in comparison to the MIRR valuation technique, interest in the use of the investment method remains high. In fact, their valuation method remains an industry standard (Kelleher & MacCormack, 2004, p. 1). A number of factors have held back the popularity of MIRR valuation technique in corporate situations. For instance, reinvestment rates vary between different companies, making the use of the method for comparison of value of investments among different companies a challenge. Previous studies show that over 70% of finance and accounting textbooks concentrate on teaching IRR, even though MIRR is a superior analytical method of valuing investments (Eagle et al., 2008, p. 70). Understandably, the use of IRR in practical situations ranges from 70% to 100% (Mackevicius & Tomasevic, 2010, p. 116). IRR technique, on the other hand, allows for easier comparison of projects from an external perspective which win the method a place as an industry standard. New Learning in MIRR Part of the problem with the growth in the use of MIRR is the reduced scholarly support for the valuation method. Studies have proven that a dismally low number of executives are aware of the weaknesses that the IRR investment technique poses, which may be part of the reason why 75% still employ the use of the technique (Kelleher & MacCormack, 2004, p. 1). The neglect has resulted in a wide unawareness in the robustness of the MIRR investment valuation method in comparison to the IRR technique. Through increased awareness in the use of the MIRR investment valuation method, growth in its use is set to increase over time. The process has to start with a greater teaching of the method in learning institutions, so that future executive leaders have a better understanding on the use and importance of the method in the valuation of investments. For instance, about a decade ago, less than 5% of the executives in America made use of the method, largely due to failure by learning institutions to incorporate MIRR into their learning curricula (Kierulff, 2008, p. 326). Class activities that have facilitated learning and understanding of IRR and MIRR The teaching of IRR and MIRR in classroom situations has been instrumental in the understanding of the IRR and MIRR. In the past, there has been a conspicuous neglect of teaching of MIRR in academics towards the close of the twentieth century (Kierulff, 2008, p. 326). Through individual assignments, class learning, and academic research, the understanding of both IRR and MIRR has become richer. Furthermore, the class activities have been instrumental in understanding the misconstrued complexities executives associate the MIRR investment valuation technique. In addition, the differences between the IRR and MIRR and the issues and shortcomings associable with either of the two methods become more apparent. Specific current and future applications and relevance in the workplace Although the IRR valuation technique and the MIRR valuation method exhibit close similarities, their most germane applications in valuation of investments vary considerably. The IRR, despite its obvious flaws in estimating the value of projects especially with regard to interim cash flow reinvestments, enjoy a wide popularity in venture capital and private equity investments. The investments usually have several cash inflows for the length of their duration, but end up in one cash outflow at the project’s closure. As such, the IRR method is still in wide usage with regard to Initial Public Offerings and Mergers and Acquisitions. On the flipside, IRR investment valuation is highly inapplicable in cases projects under evaluation will occur at differing time durations. The MIRR technique would offer a better estimate of the value of investment in the latter case, since it takes into consideration the cost of capital attributable to a project (Mackevicius & Tomasevic, 2008, p. 116). IRR valuation technique poses challenges in calculating the cost of a project, since the approach is iterative rather than analytical in nature. Sometimes the IRR technique may offer different rates of return, especially in cases where a large cash outflow occurs at the closure of the project. In addition, in such cases, it becomes highly unclear whether a high or a low rate of return is desirable for the project. The MIRR is more robust in estimation of investment options in such cases, since it takes into consideration the reinvestment aspect of a project at every stage of its life (Kelleher & MacCormack, 2004, p. 1). The MIRR method, to an appreciable extent, eliminates the necessity to employ additional techniques for selection of the most appropriate IRR rate from a set of IRR solutions on the same project. Given the ease of use of the IRR techniques, many management staff shows an inclination to use the method. The major reason for this is attributable to the reality that the IRR technique facilitates easier comparison of investments with regard to percentages in comparison to other valuation. For instance, the NPV method, although deemed ‘more accurate’ in estimating values of projects especially that are mutually exclusive, is more challenging for managers since it gives a project’s worthiness in terms of money value rather than percentages (Kelleher & MacCormack, 2004, p. 1). The growth in the use of MIRR investment method is descending, especially with the realization that it is a better valuation method in comparison to the IRR technique (Ryan & Ryan, 2002, p. 356). Despite sharing in the shortcomings associated with IRR valuation method especially with the comparison of projects, which are mutually exclusive, MIRR is a more unassuming in its estimation of an investment’s worth with regard to interim cash flows and their reinvestment. In addition, MIRR adequately helps in tackling the problem of investments that have the same IRR return. However, MIRR is more applicable in internal valuations of projects unlike the IRR technique, whose application is industry wide. The two distinguishing elements will be critical for organizations with regard to their choice valuation methods. Conceivably, MIRR valuation method will be more relevant for internal valuations while IRR technique shows more promise for industry wide comparison of projects. Conclusion The overriding purpose of this discussion is to compare Internal Rate of Return (IRR) and Modified Internal Rate of Return (MIRR) with regard to a multiplicity of factors. The issues in the discussion include the major issues that are attributable to the two closely related valuation methods, emerging issues, scholarly discussions on the subject to emerging issues and applications of the valuation methods. Generally, MIRR is an improvement on the IRR capital budgeting technique, whose driving factor is the elimination of limitations attributable to IRR. Given the highly similar premise upon the two methods originate, the method exhibits a considerable number of commonalities. For instance, both IRR and MIRR gauge the attractiveness of a project a company hopes to undertake, although to differing levels of accuracy (Kierulff, 2008, p. 327) With regard to present and future applications of the IRR and MIRR capital budgeting methods, perceptible dissimilarities begin to emerge. For instance, the use of MIRR technique is growing, although at a muted rate. However, the ability to compare projects valued with the use of IRR technique within the industry makes its use more common. Therefore, the use of MIRR is more appropriate in valuing internal projects within a company and choosing among different choices at a given time. Both IRR and MIRR have limitations in valuing mutually exclusive projects. References Eagle, D., Kiefer, D., & Grinder, B. (2008). MIRR vs. IRR: exploring the logic of the Incremental reinvestment assumption. Journal of International Finance and Economics. 8(4), 69-75. Jacobs, J. (2007). Capital Budgeting: NPV v. IRR Controversy, Unmasking Common Assertions. Social Science Research Network. Retrieved on June 7, 2012, from < http://papers.ssrn.com/sol3/papers.cfm?abstract_id=981382> Kelleher, J., & MacCormack, J. (2004). Internal Rate of Return: A Cautionary Tale. CFO. Pp. 1-2. Retrieved on June 7, 2012, from < http://www.cfo.com/article.cfm/3304945/2/c_ 3348836> Kierulff, H. (2008). MIRR: A better measure. Kelley School of Business, Indiana University. 51, 321-329. Mackevicius, J., & Tomasevic, V. (2010). Evaluation of Investment Projects in Case of Conflict Between the Internal Rate of Return and the Net Present Value Methods. Ekonomika. 89(4), 116-130. Ryan, P., & Ryan, G. (2002). Investment Practices of Fortune 1000: How have things changed? Journal of Business Management. 8(4), 355-364. Read More