Prof. Rushen Chahal
C.The internal rate of return is the discount rate that equates the present value of the project's future net cash flows with the project's initial outlay. Thus theinternal rate of return is represented by IRR in the equation below:IO =
1.The acceptance-rejection criteria are:accept if IRR
required rate of returnreject if IRR
required rate of returnThe required rate of return is often taken to be the firm's cost of capital.2.The advantages of this method are that it deals with cash flows andrecognizes the time value of money; however, the procedure is rather complicated and time-consuming. The net present value profileallows you to graphically understand the relationship between theinternal rate of return and NPV. A net present value profile is simplya graph showing how a project’s net present value changes as thediscount rate changes. The IRR is the discount rate at which the NPVequals zero.3.The primary drawback of the internal rate of return deals with thereinvestment rate assumption it makes. The IRR implicitly assumesthat the cash flows received over the life of the project can bereinvested at the IRR while the NPV assumes that the cash flows over the life of the project are reinvested at the required rate of return.Since the NPV makes the preferred reinvestment rate assumption it isthe preferred decision technique. The modified internal rate of return(MIRR) allows the decision maker the intuitive appeal of the IRR coupled with the ability to directly specify the appropriatereinvestment rate.a.To calculate the MIRR we take all the annual free tax cash
flows, ACIFt's, and find their future value at the end of the project's life compounded at the required rate of return - this iscalled the terminal value or TV. All cash
flows, ACOFt,are then discounted back to present at the required rate of return. The MIRR is the discount rate that equates the presentvalue of the free cash outflows with the present value of the project's terminal value. b.If the MIRR is greater than or equal to the required rate of return, the project should be accepted.