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Yeomin Yoon

Seton Hall University

Youngna Choi

Montclair State University

Abstract

This work shows the general relationship between the two principal capital budgeting

criteria, and then it attempts to overcome the difficulties caused by cash flows that admit

of multiple values of internal rate of retum (IRR). Modified internal rate of retum

(MIRR) is exposited. and it is thrown into clear relief A rigorous proof that for selecting

among competing (mutually exclusive) projects of equal size, the NPV and the MIRR,

unlike the NPV and the IRR, lead to the same project selection decision is provided.

/. Introduction

13, 141 indicates that, inspiteof a strong academic preference for the wefpre^enf

value (NPV) method, business executives prefer to use the internal rate of

return (IRR) method for capital budgeting decisions. Apparently, managers find

it more nattiral to analyze investment projects in terms of rates of retum than in

terms of dollars values measured by NPV.

It is well known that the IRR metliod provides proper accept or reject

solutions for capital budgeting cases with a "normal" cash flows pattern', e.g.,

an initial cash outlay or outlays (net investment) followed by a stream of

positive cash flows. It is also well known that the IRR method provides inferior

results (such as solutions conflicting with those of the NPV method and multiple

internal rates of retum) for projects with a "non-normal" pattem of cash flows,

i.e.. more than one sign change over the project's life.^

One commonly-used (and effective) way of overcoming the

shortcomings of the IRR method is to modify the IRR to make it a better

indicator of relative profitability and hence better for use in capital budgeting.

This measure is called the modified internal rate of retum (MIRR) II. 2, 6, 7, 9.

10, 14].

The purpose of this note is to provide rigorous mathematical proof that

for selecting among competing (mutuaUy exclusive) projects of equal size, the

NPV and the MIRR will, unlike the NPV and the IRR, lead to the same project

selection decision. Although this fact seems to be common knowledge among

practitioners, the autlior has uot found a simple, yet rigorous, mathematical

proof of it in any textbook or academic journal.

Net Present Value and Modified Internal Rate of Return 2375

//. Definitions

MIRR:

(=0

^ COF, ^ CIF,

IRR: (2)

C.

NPV: NPV = (3)

n = number of periods

COFj- = cash outflow (negative cash flow) at time t

= cash inflow (positive cash flow) at time t

= (general) cash flow in general at time t

k = cost of capital (discount rate) used to cotnpute NPV

= IRR

m = MIRR

The temi on tlie left in Equation (I) is simply the present value ofthe

investment outlays when discounted to the cost of capital, and tlie numerator of

the term on the r i ^ t is the sum of the fiiture (terminal) values of the cash flows.

assuming that the cash inflows are reinvested at tlie cost of capital.' Tlie

discount rate that forces the present value of the investment outlays to equal the

present value of the sum of the future (tenninal) values of the cash flows is

deflned as the MTRR.

Cj represents a general cash flow at time t, hence can take either

positive (+) or negative (-) sign. However tlie cash inflow CIF^ and outflow

COFj denote the "amount" of cash flowing in and out, respectively, at a given

time t. hence should always be positive. Sometimes it is convenient and even

necessaiy to assign for each t both C/F, dindCOFj , and it can be done using

C, as follows:

A positive cash flow ( C , > 0) implies a cash inflow, so

2676 The International Journal of Finance

(4)

Rearranging the terms in Equation (1) and using Equations (4) and (5),

(6)

c.

fc,{\+ky a

c,

(1 + /M)" (l

-C, C,

t=\ A)' (l + w)"

c. (7)

/M

Net Present Value and Modified Intemal Rate of Return 2377

The term [(l + k)/{l + m)]" in Eqtiation (7) is either larger than I, equal to 1,

or smaller than 1 for ali n

C \ +k

Thus, NPV = is larger than 0 if m > k, equal lo 0

In general, Uie NPV and the MIRR methods provide Uie same capital budgeting

decision for nonnal inveslment projects.

chatiging signs, because investment can be made even after time 0. Using

Equations and (4) and (5).

c, y c,{\+ky

2678 The International Journal of Finance

c , y Q (\+ky

c, (9)

vc, >o (1 + * )

As is the case for normal investment projects, the NPV is larger than 0

if m > k, equal to 0 if m = k, and smaller than 0 if m < k Thus, as in the case for

nonnal investment projects, the NPV and MIRR methods provide the same

capital budgeting decision for non-nonnal projects.

End notes

' Throughout the entire project period, the sign for periodic cadi flows changes only

once from plus to negative, or minus to plus.

^ See [3] for a classic example of such a situation that has become known as the "oil-well

pump problem."

^See [ 1 ] for a demonstration that the best reinvestment rate assumption is the cost of

capital for the project Ihat is implicit in the NPV method,

References

Management, 3"^ ed., Orlando, FL: Dryden Press, 1996, pp. 230-232.

Management:

3. Theory and Practice, 9"" ed.. Orlando, FL: Dryden Press, 1999, pp.

440-441,

Policy, 3'^ ed., Reading, MA: Addison-Wesley, 1988, pp. 32-26.

Net Present Value and Modified Internal Rate of Return 2379

1977), pp. 66-71.

Management Accounting (J\mt 1981), pp. 26-30.

Engineering Economist (SumniQT 1976), pp. 237-247.

Flow

8. with Explicit Reinvestment Rates: Tutorial and Extension," Financial

Review, Vol. 23, No. 3 (August 1988), pp. 369-385.

Budgeting

McGraw-Hill. 1994, pp. 420^28.

HarperCollins, 1996, pp. 194-196.

Processes," Accounting and Business Research (Summer 1983), pp.

201-208.

Analysis of Capital Budgeting Methods," Journal of Finance (March

1978), pp. 281-287.

13. D. F. Scott, Jr. and W. J. Petty II, "Capital Budgeting Practices in Large

Review (Maic\\ 1984). pp. 111-123.

Finance., l T ed.. Orlando, FL: Dryden Press, 1996. pp. 518-520.

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