IRR Vs MIRR
Capital budgeting is an essential managerial tool. One responsibility of a financial manager is to select investments with acceptable cash flows and rates of return. Therefore, a financial manager must be in a position to determine whether an investment is viable undertaking and be able to select intelligently among many alternatives.
To accomplish this, a sound process to assess, evaluate, and select projects is required. The internal rate of return (IRR) is a often financial valuation technique used by financial specialist to evaluate and assess the financial viability of capital major projects or investment. IRR is easier to learn than the outcome of the discounted cash flow (DCF) analysis for non-financial executives, it is normally applied to elaborate and justify investment decisions, however a good financial planner needs to understand that the IRR is after all estimated value, particularly when worked out, and thus should be employed in conjunction with other financial techniques for example NPV and comparable valuation multiples when showing a business or investment case.According to Young and O’Byrne (2001) The IRR is the true interest yield expected from an investment and thus it is presented as a percentage (P. 26).
They continue to explain that, due to the fact that it employs percentage approach in presentation, IRR is mostly perceived as easier to understand compared to NVP which is expressed in monetary terms. Therefore we can generally agree that IRR is the rate that makes the net present value of all cash flow to zero. The terms used for analysis are presented at the rate at which present value of a series of investments is equal to the present value of the returns on those investments.IRR takes reinvestment of interim cash flows in projects with similar rates of return (the reinvestment can be the common project or a unlike project). Therefore, IRR overemphasizes the annual corresponding rate of return for a project whose interim cash flows are reinvested at a rate lower than the considered IRR. This indicates a problem, particularly for high IRR projects, because there is often not another project existing in the interim that can earn the same rate of return as the first project.
When the calculated IRR is higher than the true reinvestment rate for interim cash flows, the standards will overestimate sometimes very considerably, the annual corresponding return from the project. The formula takes that the company has additional projects, with similar gorgeous prospects, in which to invest the interim cash flows.This makes IRR a better option for evaluating venture capital and other private equity investments, as these strategies normally needs various cash investments throughout the project, but only sees one cash outflow at the end of the project. Because IRR does not prefer cost of capital, it should not be used to weigh projects of different duration. Modified Internal Rate of Return (MIRR) does put into consideration the cost of capital and provides a better indication of a project’s effectiveness in contributing to the firm’s discounted cash flow.In the case of positive cash flows followed by negative ones, the IRR may present multiple values.
As a result of this a discount rate may be applied for the borrowing cash flow and the IRR determined for the investment cash flow. This applies for instance when a customer makes a deposit before a particular machine is developed.In a series of cash flows like, one at the beginning invests money, so a high rate of return is best, but then receives more than one possesses, so then one owes money, so now a low rate of return is best. In this case it is not even clear whether a high or a low IRR is better. There may even be multiple IRRs for a single project, like in the example 0% as well as 10%.
Examples of this type of project are strip mines and nuclear power plants, where there is usually a large cash outflow at the end of the project.In general, the IRR can be calculated by solving a polynomial equation. Sturm’s theorem can be used to determine if that equation has a unique real solution. In general the IRR equation cannot be solved analytically but only iteratively.When a project has several IRRs it may be more suitable to calculate the IRR of the project with the advantages of reinvestment. Consequently, MIRR is applied, which has an assumed reinvestment rate, normally similar to the project’s cost of capital.
Even though there is a strong academic preference for NPV, studies have found that executives prefer IRR over NPV. Actually, managers find it reasonable to compare investments of various sizes in terms of percentage rates of return than by value of NPV. Nevertheless, NPV continues to be “more accurate” reflection of value to the business. IRR, as a standard of investment effectiveness may give better insights in capital inhibited circumstances. However, when comparing mutually exclusive projects, NPV is the appropriate standard.According to Jaisingh (2005) “statistics is the science of collecting, organizing, summarizing, analyzing and making inferences from the data” (P.
4). Interpretation of data is important because it provides useful or helpful information to the organization and especially management team which makes decision. Raw data is collected and interpreted to give a meaningful report. This is done by statisticians who have sound knowledge of statistic techniques. Statistical methods can be viewed from two approaches; descriptive statistics and inferential statistics.
The both approaches interpret data from different perspective and are applicable better to different conditions.Looking at the capital budgeting in terms of either debt or equity, capital is a much constrained resource. There is a limit to the volume of credit that the banking system can create in the economy. Commercial banks and other loaning institutions have maximum deposits from which they can give loans to individuals, corporations, and governments. Additionally, the Federal Reserve System needs each bank to keep part of its deposits as treasury. Having constrained resources to lend, the financial institutions are selective in offering loans to their clients.
But even though a bank were to offer unlimited loans to a company, the management of that company would need to consider the effects that mounting loans would have on the overall cost of financing.Actually, any firm has restricted borrowing resources that should be given among the best investment options. One might reason that a company can give an almost unrestricted amount of common stock to increase capital. Advancing the number of shares of company stock, however, will enable only to share the common amount of equity among a bigger number of shareholders. This means, as the number of shares of a company advances, the company ownership of the individual stockholder may proportionally go down.
The perception that capital is a constraint resource is true of any form of capital, whether debt or equity or retained earnings, accounts payable or notes payable, and so on. Also the best-known firm in an industry or a community can improve its borrowing up to a certain edge. Once this point has been attained, the firm will either be deprived of more credit or be charged an advanced interest rate, making borrowing to be undesirable means of raising raise capital.Salkind (2009) say descriptive statistics are used to organize and describe the characteristic of data set (P. 8).
Descriptive statistic only interprets data without inferring or giving suggestion. It is used to explain the fundamental features of the data being studied. These features are described in quantitative terms which summarize the dataset. The three common descriptive statistics includes; mean, median, and mode. Descriptive statistic can be applied in an organization for different purposes, for example when an organization wants to determine average performance of employees, the grade of the employees, among other quantitative reports.
This approach is best suited to this scenario because the reports required are only for interpreting the current state of the data set.Inferential statistics has also been explained by Salkind (2009) as the next step after collection and summarizing data. They are used to make presumption from smaller group of data normally called sample to a possibly larger one (P. 9). A sample is chosen from which inference about population is drawn. Inference statistics employs two methods which are; estimation and hypothesis testing.
In estimation method a random sample is taken to estimate parameters of the target population. The other method of inferential statistics, works by introducing two opposing hypothesis concerning parameters in the pollution. Population is then sampled and evidence extracted from the sample data and decides which hypothesis is best supported. In this method errors are recognized and presented.Inferential is commonly used in an organization to check factors which affects production. For example an organization uses inferential statistics to determine how number of working hours relates to unit produced.
This method is best suited in this case because small sample data can be used to interpret the entire population. The results are then used by management to make effective decisions.A number of surveys have shown that, in practice, the IRR method is more popular than the NPV approach. The reason may be that the IRR is straightforward, but it uses cash flows and recognizes the time value of money, like the NPV. In other words, while the IRR method is easy and understandable, it does not have the drawbacks of the ARR and the payback period, both of which ignore the time value of money.
The main issue with the IRR approach is that it frequently offers unrealistic rates of return. Suppose the cutoff rate is 11% and the IRR is computed as 40%. This does not imply that the management should right away acknowledge the project because its IRR is 40%. This is because an IRR of forty percent assumes that a firm has the chance to plow future cash flows at 40%. When it is certain from past experience that, the economy shows that 40% is an impractical rate for future reinvestments, an IRR of 40% is suspect. Basically speaking, an IRR of 40% is too fair to be true! So unless the computed IRR is a reasonable rate for reinvestment of future cash flows, it should not be applied as a yardstick to take or reject a project.
Another issue with the IRR method is that it may give various rates of return. Suppose there are two discount rates that make the present value equivalent to the preliminary investment. In this case, which rate should be applied in comparison with the cutoff rate? The main concern of this question is not to determine the issues where there are different IRRs. But the aim is to let people know that the IRR approach, despite its popularity in the business world, involves more issues than a practitioner may assume.The MIRR is comparable to the IRR, however is theoretically higher in that it overcomes two shortcomings of the IRR. The MIRR properly assumes reinvestment at the project’s cost of capital and avoids the issue of several IRRs.
However, it is important to note that the MIRR is not applied as widely as the IRR is.In conclusion we can generally agree that statistical information is very important for organizational decision making. McPherson (2001) “say statistics has changed from a tool used in specialized areas of research and development into an important component of business, industry, and government” (p. 1). Therefore organizations should make use of statistical reports to plan and focus their future in the business.
