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Yeomin Yoon
Seton Hall University

Youngna Choi
Montclair State University


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

Numerous surveys ofthe capital budgeting practices 14, 5, 7, 8, 11, 12,

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


^ COF, ^ CIF,
IRR: (2)

NPV: NPV = (3)

where t = time subscript or superscript

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
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

CIF, =C, and COF, =0


A negative cash flow ( C , < 0) implies a cash outflow, so

CIF, = =-C, (5)

///. For "Normal" Inve^ment Projects

In this case Co<Oand C, > O f o r t = 1,2,3, ..,n.

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


Therefore, Equation (3) becomes


fc,{\+ky a

(1 + /M)" (l

-C, C,
t=\ A)' (l + w)"

c. (7)
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

if m = k. smaller than 0 if m < k.

In general, Uie NPV and the MIRR methods provide Uie same capital budgeting
decision for nonnal inveslment projects.

IV. For "Non-Normal" Investment Projects

For a non-normal investment project, the cash flows C,^s have

chatiging signs, because investment can be made even after time 0. Using
Equations and (4) and (5).

COF, = - C , and CIF, = 0 for C, < 0,

COF, =Oand C/F, = C, for C , > 0 ,

and MIRR is an m that saUsfies^

Rewriting Equation (3) in terms of Equation (8),

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,

•*" V C , " means "for all C^ ".


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