IRR v. MIRR Valuation Methods

IRR v. MIRR Valuation Methods

Introduction

In valuation methods, there are valuation methods that can be used to appropriately allocate the needed resources. This method is often called as the capital budgeting that can improve both of the timing and the quality of the provided funds. The invested projects are expected to be fruitful according to the forecasted time. Furthermore, it is favorable if the organization realizes the profit faster or earlier than expected. But beyond the given timeline will create a great impact such as losses to the organization if the forecasted is delayed or not achieved in the given specific period.

Managing Finances

In an organization, there is only one department that handles the finances of the enterprise. Within the finance department, the finance manager is expected to attend the needs of the project manager and his team. Together, both can do their tasks and provide the quality of service. In focusing to the capital budgeting, the valuation methods are emphasized to generate a decision on whether accept or not the proposed project. Accordingly, there are four main methods of appraisal that can be used (Accounting Rate of Return, Payback, Net Present Value and Internal Rate of Return) that can provide the reliable investment decisions (University of London External System).  Financial managers make decisions regarding which assets that the firm should acquire; how the assets should be financed, and how the firm should manage the existing resources. And in order to provide these responsibilities, the finance manager should perform the most preferred valuation method (Quality Assurance Bureau, 2007).

IRR and MIRR, Which is better?

The Internal Rate of Return (IRR) is the first valuation that this paper will discuss. The underlying principle of IRR is to present the expected rate of return of the project. If the IRR exceeds the cost of funds used to finance the project, a surplus remains after paying for the capital, and this surplus accrues to the firm’s stockholders. Therefore, taking the project which the IRR exceeds its cost of capital increases shareholder’s wealth. On the other hand, if the IRR is less than the cost of capital, then the decision to take on the project imposes a cost on current stockholders. This behavior indicates that there is a “break-even” which makes the IRR useful in the process of valuation among the capital projects (Brigham & Gapenski, 1997). The basic rule in accepting the project under the valuation method of IRR is to accept the project which has the greater number of required rate of return, or otherwise, reject the project.

However, with an aim to easy analyze the investments in terms of the percentage rate of return, then there is a modified version of IRR which is called the Modified Internal Rate of Return (MIRR). The MIRR is a better indicator of relative profitability which is also means that it is better in capital budgeting. This fact is argued by investigating the differences and similarities of the two methods. MIRR has a significant advantage over the regular IRR, this is because, MIRR assumes that the cash flows from the invested projects are reinvested at the cost of capital; while the regular IRR assumes that the cash flows are reinvested at the project’s own IRR. Since reinvestment in capital is better assumption, the MIRR is better indicator of the project’s true profitability (Brigham & Gapenski, 1997). MIRR overcomes the two weaknesses of IRR which correctly assumes the reinvestment and avoids the problem if multiple IRRs. The practice of this application is centered on three steps: (1) estimate all cash flows as in IRR; (2) calculate the future value of all cash flows at the last year of the project’s life; and (3) determine the discount rate that causes the future value of all cash inflows to be equal to the firm’s investment at time zero.

Conclusion

Capital budgeting is a required managerial tool and the finance manager is the one responsible in making such decisions in terms of investments. It is important that before the valuation, the finance manager already decided what the appropriate method to be used and should emphasize if the chosen investment is worth undertaking. Therefore, the elements to generate a sound decision are to evaluate, compare, and select the project in a timely manner. However, there is an instance that if the proposed projects are different in scale or in size, then conflicts might occur, like comparing a large scale of project to the small scale of proposed project. Still, MIRR remains superior to the regular IRR to represent or assess the expected long-rate of return of a project. 

 

References: 

Brigham, E., & Gapenski, L., (1997) Financial Management: Theory and Practice. The Dryden Press, 8th Ed. 

Quality Assurance Bureau, (2007) Internal Control Guide [Online] Office of the Comptroller, Accessed 10 August 2010, from http://www.mass.gov/Aosc/docs/business_functions/bf_int_cntrls/Internal_Control_Guide_Volume_I.pdf

University of London External System. Chapter2: Basic Investment Appraisal Methods, Finance Management, Accessed 10 August 2010, from http://www.londonexternal.ac.uk/current_students/programme_resources/lse/lse_pdf/further_units/fin_man/59_ch_02.pdf

 

Credit:ivythesis.typepad.com