Modified internal rate of return (MIRR) - P4/P5

This article introduces the concept of MIRR and may be more useful for P5 than P4.
MIRR is developed to address the weaknesses of IRR. Both of them are used to identify the margin of safety of the project. IRR has a number of problems:
1. Multiple IRR can occur when the cash flows are unconventional. Conventional cash flows situation is when the project starts with investment cost and then cash inflows in later years.
2. Unrealistic reinvestment assumption. IRR assumes that cash flows of the project can be reinvested at IRR rate. This means that cash flows generated during the project life are being reinvested to the project at IRR rate but the more appropriate rate should be the cost of capital rate (because we calculate NPV by assuming cost of capital is the reinvestment rate).
3. There may be mutually exclusive projects (eg. IRR is more than cost of capital but NPV is negative). In this situation, NPV is more superior and preferred.

MIRR solves the above problems. It assumes that the reinvestment rate is cost of capital and this is the only difference compared to IRR. MIRR decision will be the same with NPV decision.
MIRR = (PV of return phase/PV of investment phase)^(1/n) x (1 x reinvestment rate) - 1.
MIRR will always be lower than IRR, showing the more realistic margin of safety.

Example: PV of cash inflows = $1000, PV of investment cost = $500, time period considered = 5, cost of capital = 10%. Calculate MIRR.
Solution: MIRR = (1000/500)^(1/5) x 1.1 - 1 = 26.4%. Clearly, the project is financially acceptable since MIRR is higher than cost of capital.

In P5, you may be required to calculate MIRR but it will not be tough, probably together with NPV and you can use the figures you calculated during NPV computation to calculate MIRR. In P4, you know that you can calculate MIRR in an alternative way: MIRR = (PV of terminal value of cash inflows/PV of investment phase)^n - 1. This is not covered in this article.