Internal Rate of Return & Modified Internal Rate of Return PWC Course Notes P53 Mark Fielding-...
Transcript of Internal Rate of Return & Modified Internal Rate of Return PWC Course Notes P53 Mark Fielding-...
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Internal Rate of Return & Modified Internal Rate of ReturnPWC Course Notes P53
Mark Fielding- Pritchard
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Advantages and Disadvantages of the IRR
Advantages
% so people feel they understand it
Rate of return
Relatively easy to calculate
Widely accepted
No need to pick a discount rate
Disadvantages
% so 20% of $1 is better than 15% of $1m
How to benchmark
Multiple IRRs
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We have a potential coal mining project in Scotland. There will be an initial investment in purchase of land, licenses, equipment. We can harvest coal from the
surface so the NPV quickly becomes positive. Once exhausted we must dig down to the next seam which requires expenditure so the NPV becomes negative, once
mining resumes we receive sales and he NPV becomes positive
Net Present ValuesYear 1 -20Year 2 2.5Year 3 -6Year 4 4.5Year 5 12
Internal Rate of Return
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Year 1 Year 2 Year 3 Year 4 Year 5
-25
-20
-15
-10
-5
0
5
10
15
-20
2.5
-6
4.5
12
Mining Project
Time
Net
Pre
sent
Valu
e
Internal Rate of Return
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Modified IRR Used to counter the fact that we get multiple IRRs
Year Net after tax cash flow $
0 -20
1 7
2 -3
3 12
4 10
Company uses discount rate of 10%Note that for exam purposes we are looking here at cash flows, not NPV
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MIRR
Year Net after tax cash flow $
Inflow Outflow
0 -20 20
1 7 7x(1+0.1)³ = 9.32
2 -3 3x = 2.48
3 12 12x1.1= 13.2
4 4 4
Total 26.52 22.48
What we are doing is smoothing the cash flows so that we don’t get multiple IRRS. We make 2 assumptions- All expenses (negative numbers) occur at time 0- All income (positives) occur at time 4- Discount rate 10%
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MIRR
Therefore at IRR the NPV of the outflows = NPV of inflows22.48 T0 = 26.52 at T4 , so22.48 = 26.52 where k is the discount rate (so the IRR)= 1.18K= 4.22%So if MIRR is > cost of finance or threshold then we accept the project