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MIRR: A better measure

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  • Kierulff, Herbert
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    Abstract

    Over the past 60 years Net Present Value (NPV) and the Internal Rate of Return (IRR) have emerged from obscurity to become the overwhelming choices for the quantitative measurement of investment attractiveness in modern corporations. Despite their current popularity, neither NPV nor IRR was designed to deal effectively with the vast majority of investment problems, meaning those where periodic free cash flows are generated between the time of asset purchase and the time of sale. NPV assumes that periodic cash flows can and will be reinvested at the NPV discount rate, either at the cost of capital or another risk adjusted discount rate; IRR assumes reinvestment at the IRR. Neither assumption is usually realistic. In addition, when evaluating projects in terms of their financial attractiveness, the two measures may rank projects differently. This becomes important when capital budgets are limited. Finally, a project may have several IRRs if cash flows go from negative to positive more than once. The Modified Internal Rate of Return (MIRR), discovered in the 18th century, does account for these cash flows. This article explains the problems with NPV and IRR, describes how MIRR works, and demonstrates how MIRR deals with weaknesses in NPV and IRR.

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    File URL: http://www.sciencedirect.com/science/article/B6W45-4SR0V1K-9/1/fbfd5ecd6f84a2d49cc47e4b4d31b74f
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    Bibliographic Info

    Article provided by Elsevier in its journal Business Horizons.

    Volume (Year): 51 (2008)
    Issue (Month): 4 ()
    Pages: 321-329

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    Handle: RePEc:eee:bushor:v:51:y:2008:i:4:p:321-329

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    Web page: http://www.elsevier.com/locate/bushor

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    1. James H. Lorie & Leonard J. Savage, 1955. "Three Problems in Rationing Capital," The Journal of Business, University of Chicago Press, vol. 28, pages 229.
    2. McDaniel, William R & McCarty, Daniel E & Jessell, Kenneth A, 1988. "Discounted Cash Flow with Explicit Reinvestment Rates: Tutorial and Extension," The Financial Review, Eastern Finance Association, vol. 23(3), pages 369-85, August.
    3. Harold Bierman & Seymour Smidt, 1957. "Capital Budgeting and the Problem of Reinvesting Cash Proceeds," The Journal of Business, University of Chicago Press, vol. 30, pages 276.
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    Cited by:
    1. Mária Illés, 2012. "Transforming the Net Present Value for a Comparable One," Theory Methodology Practice (TMP), Faculty of Economics, University of Miskolc, vol. 8(01), pages 24-32.
    2. Simone N. Tuor & Uschi Backes-Gellner, 2010. "Risk-return trade-offs to different educational paths: vocational, academic and mixed," International Journal of Manpower, Emerald Group Publishing, vol. 31(5), pages 495-519, September.
    3. Suzette Viviers & Howard Cohen, 2011. "Perspectives on capital budgeting in the South African motor manufacturing industry," Meditari Accountancy Research, Emerald Group Publishing, vol. 19(2), pages 75-93, October.

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